THE EFFECT OF INFLATION ON FIXED-INCOME INVESTMENTS
Learn even more about this topic with the Encyclopedia of Personal Finance™
Fixed-income investments, such as bonds and Treasury bills,
generate income for their investors by paying out a set rate of interest.
Generally, when you think about interest rates, the
nominal interest rate is what you are thinking about. The 9
percent interest rate on a mortgage, the 4 percent rate on a Treasury bill, or
the 10 percent rate on a corporate bond are all examples of nominal interest
A real interest rate, by contrast, is
the rate of return adjusted for inflation. It measures the rate of growth of
your purchasing power.
If you invest in a bond that pays out 6 percent annually, and
inflation averages 6 percent over the course of your investment, your real
return is 0 percent. You have gained nothing by investing your money in this
bond. The good news is that you have not lost anything either. If you had
invested in a bond that provides a 3 percent nominal rate of return, you would
have lost 2.83 percent in terms of purchasing power.
Let's look at the formula for calculating real interest
The fact that future inflation rates are uncertain makes your
future real interest rate returns uncertain as well. Even though an investment
may guarantee you a certain nominal rate, there is no guarantee that you will
achieve your desired real rate of return. The best that you can do is to attempt
to predict future inflation rates or look at others' expectations of future
inflation and base your investment decisions accordingly.
If inflation is high, you will need a proportionately higher
nominal rate of return to ensure that you receive your expected real rate of
return on your fixed-income investments.
For example, to get a real rate of return of 4 percent in a 3
percent inflationary environment, you would need a nominal rate of return of
Inflation can be a serious problem for fixed-income
investors. But what is its effect on stocks?