What it is:
How it works (Example):
For example, $1,000,000 in bonds with a 10% coupon might generate enough interest payments for a retiree to live on, but with an annual 3% inflation rate, every $1,000 produced by the portfolio will only be worth $970 next year and about $940 the year after that. The rising inflation means that the interest payments have less and less purchasing power. And the principal, when it is repaid after several years, will buy substantially less than it did when the investor first purchased the bonds.
Some securities attempt to address this risk by adjusting their cash flows 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 for changes in the consumer price index, thereby giving the investor a guaranteed real return.
Some securities inadvertently provide some load9-risk protection. 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 the prime rate that are directly or indirectly affected by inflation rates. Convertible bonds also offer some protection because they sometimes trade like bonds and sometimes trade like stocks. Their correlation with stock prices, which are affected by changes in inflation, means convertible bonds provide a little inflation protection.
Why it Matters:
Although the record inflation of the 1970s is history, inflation risk is still a common worry for income investors. Inflation causes money to lose value, and any investment that involves cash flows over time is exposed to this inflation risk. The ramifications of this can be serious: The investor earns a lower return that he or she originally expected, in some cases causing the investor to withdraw some of a portfolio's principal if he or she is dependent on it for income.
It is important to note that inflation risk isn't the risk that there will be inflation, it is the risk that inflation will be higher than expected. This is one reason investors and analysts speculate considerably about inflation rates and study indicators such as the yield curve to get a feel for where inflation rates are headed. For example, many economists believe that a steep normal yield curve means investors expect higher future inflation and a sharply inverted yield curve means investors expect lower inflation.