How Inflation Can Eat Your Lunch

Inflation not only hurts us as consumers, but it can also hurt us as investors, especially as holders of ordinary bonds and as potential borrowers.

Paul D. Kaplan 9 November, 2022 | 1:35AM
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Paul Kaplan: I'm Paul Kaplan, Director of Research at Morningstar, Canada. John Maynard Keynes, one of the most influential economists of the 20th century, wrote that the best way to destroy the capital system is to debauch the currency. By debauch the currency Keynes meant how excessive inflation makes a given amount of money able to buy fewer and fewer goods, or conversely, the same items costing more and more. While the current bout of inflation may not be putting our entire capital system at risk, it can have major effects on us as investors. If you hold ordinary bonds or hold shares of an ordinary bond fund, the value to you of the payments on the bonds, coupons and future value is shrinking because the payments can buy fewer and fewer goods. This makes bonds worth less.

Another way to look at the impact of inflation on bonds is to look at interest rates or bond yields. In the first part of the 20th century, the economist Irving Fisher had an insight that an interest rate can be decomposed into two components. One – the real interest rate and two – the expected inflation rate. The real interest rate is what the interest rate would be in the absence of inflation. It's determined by the underlying economy. The expected inflation rate is the rate of inflation that investors are expecting as opposed to unexpected inflation, which is inflation that investors do not see coming. If expected inflation rises, interest rates and bond yields rise, lowering bond prices and thus reducing the wealth of bondholders, including holders of bond funds. Fortunately, there is an alternative to ordinary bonds that provides inflation protection – real return bonds issued by the Government of Canada.

Now, let's turn to another impact of inflation. Suppose you were considering borrowing money, such as taking on a mortgage, or suppose that you have an existing mortgage that is coming to term, so you need to refinance the remaining principal. Either way, inflation affects you because it raises the cost of borrowing. When inflation causes interest rates to rise, the monthly payment on a new mortgage rises. For example, suppose that five years ago, you took out a $300,000 mortgage at 3% amortized over 25 years. Your monthly payment has been $1,423. Now, you need to refinance the remaining balance of $256,516. However, due to a rise in expected inflation to refinance the remaining balance over 20 years, your mortgage payments rise to $1,838. This is a 29% increase. Hence inflation not only hurts us as consumers, but it can also hurt us as investors, especially as holders of ordinary bonds and as potential borrowers.

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Paul D. Kaplan  Paul D. Kaplan, Ph.D., CFA, is director of research with Morningstar Canada.

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