In my post, Statement Shock: Bonds in the Red, I discussed why bond prices drop when interest rates rise and why this shouldn’t matter much to investors with a sufficient time horizon. While low yields and the short-term threat of price volatility may be unsettling to some fixed income investors, the real enemy is inflation. Here’s why…
Unlike stock investments, bonds are legal contracts between a lender (the investor) and a borrower (typically a government or company). The terms of the contract are fixed at the time the lender enters into the agreement and (at their most basic level) include a fixed rate of interest that the borrower will pay to the lender over the term of the contract. For example, investors today can lend money to the Government of Canada for a period of 10 years and expect to receive approximately 3% per year on those funds.
Inflation is the average increase in prices that an economy experiences over time. If you can buy a Starbucks coffee today for $2.00, you can be fairly certain that it will cost more than this 10 years from now. Herein lies the problem. Bonds are contracts with fixed payments and inflation will erode the value of those payments (and the principal) as time passes. Let’s walk through an example.
If I purchase a 3% bond for $10,000, I can rest assured that I will receive everything that I was promised. Each year I will receive $300 in interest payments and my $10,000 back at the end of the contract. However, because of inflation, the $300 I receive in year 10 will buy a lot less than the $300 I receive in year one, and ditto for the principal handed back to me at the end of the contract. In fact, if inflation rises to the same level as the interest rate on my bond (3%), then I am not receiving any real return on my investment because prices are going up at the same rate as my yield.
Inflation in Canada is currently hovering around 1.5% per year, so 10-year bond investors are being rewarded with a 1.5% real yield (3% coupon – 1.5% inflation). Historically, this is a low level of inflation, below the 2% target set by the Bank of Canada, and the Bank of Canada is currently making efforts to increase the level. Think of it this way: the Government of Canada will borrow your money today and pay you 3% per year, while the Bank of Canada will do its best to erode your return by increasing the level of inflation!
While there are risks, bonds remain an important part of an investment portfolio. They are an excellent diversifier of risk and one of the best asset classes to own in deflationary periods.
Next in the series I will discuss why equities may be better at protecting investors against the wealth-eroding effects of inflation.