Foundations For Fixed Income And Inflation By: Gabriel PotterMBA, AIFA® 2013.08.14

We have recently spent some time discussing some of the challenges to fixed income investing from a macro-economic perspective, particularly in regards to potentially rising interest rates.  There is another element to fixed income investing that is sometimes ignored by advisors and investors alike:  inflation.

Here is a simple example.  Imagine a world with only two investments:  you can invest in “bond ABC” or “equity XYZ”.  In this imaginary world, imagine the bond ABC experiences no price volatility (i.e. – the investment is riskless) and it achieves a 6% total return.  On the other hand, equity XYZ does experience high price volatility and it achieves, over the long term, only an 7.5% total return.

Ignore the math and just think of this intuitively for a moment.  Which investment seems better?  I’d argue that the bond ABC feels relatively better for most investors since the marginal gain (1.5% of return) may not be worth the uncertainty in price.  Given the choice, I suspect investors may feel like putting most of their assets in the bond ABC holding.

Now, we’re still considering living in that world, but here is some more information for you.  In this imaginary world, inflation is 5.5% per year.  Prices for every product you buy get more expensive by more than 5% a year.  So, the bond ABC only gets a marginal return (0.5%) after inflation whereas equity XYZ achieves a modest (2%) of real return after inflation.  In other words, the real return of the equity investment is now 4 times higher than the bond investment. 

Does the equity investment feel more attractive now?  At first glance, I imagine many of our readers would be willing to bear higher allocations to the equity XYZ holding.  But how much more?  This depends greatly on the particular investor’s goals.  For instance, a pension plan with fixed liabilities (i.e. - they do not depend on inflation) may be relatively indifferent to equities, whereas an individual employee trying to build wealth for retirement might be very sensitive to inflation risk.

Again, this is an extremely basic example.  In the real world, inflation has been very contained since the financial crisis and, indeed, a number of economists have been equally worried about deflation.  The point here is simply that your unique goals and the relevant information should determine your outlook and investment positioning.

 

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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