What Is Inflationary Risk?
Inflationary risk is the risk that the future real value (after inflation) of aninvestment, asset, or income stream will be reduced by unanticipated inflation.
Key Takeaways
- Inflationary risk is the risk that inflation will undermine an investment's returns through a decline in purchasing power.
- Bond payments are most at inflationary risk because their payouts are generally based on fixed interest rates, meaning an increase in inflation diminishes their purchasing power.
- Several financial instruments exist to counteract inflationary risks.
Understanding Inflationary Risk
Inflationary riskrefers to therisk that inflation will undermine the performance of aninvestment, the value of an asset, or the purchasing power of a stream of income.Looking at financial results without taking into account inflation is the nominal return. The value an investor should worry about is thepurchasing power, referred to as the real return.
Inflation is a decline in the purchasing power of money over time, and failure to anticipate a change in inflation presents a risk that the realized return on an investment or the future value of an asset will be less than the expected value.
Any asset or income stream that is denominated in money is potentially vulnerable to inflationary risk because it will lose value in direct proportion to the decline in the purchasing power of money. Lending a fixed sum of money for later repayment is the classic example of an asset that is subject to inflationary risk because the money that is repaid may be worth significantly less than the money that was lent. Physical assets and equity are less sensitive to inflationary risk and may even benefit from unanticipated inflation.
For investors, bonds are considered most vulnerable to inflationary risk.Just as a moth can ruin a great wool sweater, inflation can destroy the net worth of a bond investor. And far too often, once a bond investor notices the problem with their investment, it is too late.
Most bonds receive afixed coupon ratethat doesn't increase. Therefore, if an investorbuys a 30-year bond that pays a four percentinterest rate, but inflation skyrockets to 12%, the investor isin serious trouble. With each passing year, the bondholderlosesmore and more purchasing power, regardless of how safe theyfeel the investment is.
Counteracting Inflationary Risk
The most fundamental way of protecting against inflationary risk is to build an inflation premium into the interest rate or required rate of return (RoR) demanded for an investment. For example, if a lender expects that the value of money will decline by 3% in the course of one year, they can add 3% to the rate of interest that they charge to compensate. Inflation premiums like this are implicitly built into everyday market interest rates by lenders and borrowers.
More serious inflationary risk occurs when the actual rate of inflation turns out differently from what is anticipated. Simply building an inflation premium into a required interest rate or RoR when making an investment cannot adjust for unanticipated inflation.
Some securities attempt to address inflationary risk by adjusting theircashflows for inflation to prevent changes in purchasing power. Treasury inflation-protected securities (TIPS) are perhaps the most popular of these securities. They adjust their coupon and principal payments according to changes in the consumer priceindex (CPI), thereby giving the investor a guaranteed real return based on the actual inflation rate.
Some securitiesprovide inflationary riskprotection without attempting to do so. For example, variable-rate securities provide some protection because their cash flows to the holder (interest payments, dividends, etc.) are based on indices, such as theprime rate, that are directly or indirectly affected by inflation rates. Convertible bonds alsooffersome protection because they sometimes trade like bonds and sometimes trade likestocks. Their correlation withstockprices, which are affected by changes in inflation, means convertible bonds provide a little inflation protection.
Example of Inflationary Risk
Consider an investor holding a $1,000,000 bond investmentwith a 10%coupon. Thismight generate enough interest payments for a retiree to live on, but with an annual 3%inflationrate every $1,000 produced by the portfoliowillonly be worth $970 nextyearand about $940 the year after that.
Rising inflation means that the interest payments have progressively lesspurchasing power, and theprincipal, when it is repaid after several years, will buy substantially less than it did when the investor first purchased the bond.
