What is inflation Risk?

 

I have referred to investment risk very many times in the past. This is a really scary risk in the Indian context NOW, as the inflation rates are sky rocketing.

What exactly is Inflation risk?

Inflation risk is the danger that an increase in price levels (normally for a sustained period of time)  will undermine the purchasing power of a bond’s fixed interest payments. In case of a portfolio we normally try to earn more than the inflation rate.

The Real Return of a portfolio = Nominal return MINUS inflation.

Investors often are attracted to bond (this includes income funds, income opportunity funds, floating rate funds, gilt funds, etc. – normally talking of debt funds with maturity exceeding ONE year) mutual funds because of their regular payouts from interest earnings. These payouts, ARE, subject to inflation risk. Inflation erodes the purchasing power of any investment. It is particularly scary for investments that pay out a fixed stream of interest over a period of time, such as bonds, national savings certificates, post office schemes, and of course the Indian favorite, BANK deposits. As inflation increases the prices of goods and services, investors find that their interest earnings are not keeping pace.

For example, suppose Rs. 10,000 in a bond (remember we are talking of a single bond like State Bank of India bond)  earns 9% interest, but inflation is 8 percent per year. Although this bond will earn Rs. 900 in interest every year, inflation will make goods and services more expensive. Initially, the Rs.500 in interest will buy a certain amount of goods and services (a basket). After a year, that same basket will cost Rs. 972  because of inflation, but the investor will still only receive Rs. 900 in interest income. Year after year as prices rise, the same Rs. 900 in interest earnings will buy lesser and lesser goods and services in the market. This is what is meant by inflation eroding the purchasing power of an investment. The longer a bond’s maturity, the greater its inflation risk. Bond yields often incorporate expectations of inflation so that investors are compensated for expected inflation risk. If inflation rises by more than was expected when the bond was issued, investors will find that the interest and principal returned to them will be worth less than they had anticipated.

So when the market expects higher inflation in the future, the market expects the bond issuer to pay a high rate of interest, for longer duration bonds. So if SBI were to come out with an issue today people WILL EXPECT SBI to pay about 9.3 % interest – simply because the CPI figures are pretty close to this number.

CPI: Consumer Price Index.

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3 Responses to “What is inflation Risk?”

  1. Good explanation sir.


    Initially, the Rs.500 in interest will buy a certain amount of goods and services (a basket). After a year, that same basket will cost Rs. 972 because of inflation, but the investor will still only receive Rs. 900 in interest income.

    I am sure you meant Rs 900 and not Rs 500.

  2. Subra Sir

    Inflation affects everybody. Agreed.

    Now Sir, please give us (common folks) some ideas how to tackle it

    1) e.g. if the price of tea, sugar is increased one can avoid or reduce the consumption hence money will not be spend more than what was being spent earlier? If the cost of toor daal increases replace it with other daal, lentil whichever is cheaper.

    2) Inflation is calculated on various factors and correct me if I am wrong if one has fully paid up home and does not require to go to work eveyrday. The price increase in building material, labour & petrol shd not affect that person as much. Yes I do understand fuel cost affects energy prices, transport cost hence all products that are driven from one end to another etc but my point is with less or alternative product consumption the overall effect of inflation can be tackled? am I being too naive here?

  3. SubraJi

    Would really appreciate if you can guide us.
    Equity MFs investment has its risk. No one can predict future of stock mkt.

    Direct stock investing is in same bucket.

    Fixed Income MF gives returns which when compared to inflation seems less.

    RE – never dabbled. Seen lots of guys talking of 10-20% returns in matter of weeks (scary!!!!)

    So what should one do?
    Invest in equity MF and hope for the best?????

    Please guide us…

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