What is Inflation Risk?
Inflation risk is the risk that the purchasing power of your investment returns will be reduced by increasing inflation. Rising inflation that causes an increase in prices effectively lowers the real return of a given investment.
Inflation risk impacts investor's portfolio planning, especially in regards to retirement spending. The higher the inflation, the less purchasing ability a retiree will have when living on their investments.
Inflation risk is especially impactful to fixed-income assets, such as bonds, as their fixed rate of return becomes less valuable year after year with rising inflation. This is also true of savings accounts, which typically do not pay enough interest to keep up with natural inflation, let alone in a rising inflation environment.
Inflation Risk Example
Tom owns $500,000 in government bonds in his retirement portfolio. These bonds provide a 5% bond coupon annually, paying Tom $25,000. If inflation is 3% annually, Tom's $25,000 income is reduced in purchasing power to the equivalent of $24,272. The next year, the income from the bond has an equivalent purchasing power of $23,565.
While the bond is valued in today's dollars, annual inflation is effectively reducing the real rate of return on Tom's investment, as $25,000 can't buy as much in the future as it does today.
This is why it's so important to calculate inflation risk into investment planning, as the risk of inflation can reduce what investors can afford in the future.
How is Inflation Risk Measured?
Inflation risk considers various metrics in determining how investors should view the future outlook of rising prices. Here are the two most popular ways to understand what future inflation risk may be:
Yield curve. The yield curve can give an indication of where inflation may be headed. A steep normal yield curve means that investors may expect higher future inflation. A sharply inverted yield curve can mean that investors may expect lower inflation.
CPI Data. The U.S. Bureau of Labor Statistics puts out a monthly report about consumer prices and measures the average change in prices over time, known as the Consumer Price Index (CPI). This is a real-time measure of inflation, showing an increase or decrease in consumer prices in various sectors.
How to Counteract Inflation Risk
To combat rising prices and inflation risk, there are several investments that help build a hedge against rising inflation.
Treasury Inflation-Protected Securities (TIPS). TIPS are, by definition, inflation-protected, with coupon and principal payments rising and falling with changes to the consumer price index. TIPS can be purchased in terms of 5, 10, and 30 years.
Variable-rate securities. Some securities offer to pay a variable interest rate (such as variable-rate CDs) based on indices such as the prime rate and rise with increased interest rates.
Convertible bonds. Convertible bonds offer some protection because they're occasionally traded like bonds or stocks. Their correlation with stock prices – which are affected by changes in inflation – means that convertible bonds provide slight inflation protection.
REITs. Real Estate Investment Trusts (REITs) are investment funds that allow investors to invest small amounts into real estate projects. This can be a hedge against inflation because housing prices and rents typically rise along with inflation.
The Bottom Line on Inflation Risk
Inflation risk is real, and in a low-interest-rate environment, understanding how to compensate for it can help you plan your investment strategy effectively. Whether you adjust your long-term retirement target by basing your calculations on an inflation-adjusted rate of return, or you look for other investment hedges against inflation, calculating for inflation is crucial to building a successful investment plan.