Why is Inflation Bad for Bonds?

So, why is inflation bad for bonds? How does it affect the bonds? Inflation can cause drastic changes in your financial planning and can cause collateral damage to your investment.
As inflation surges, people are always keeping a watchful eye on the changing figures. It is quite natural that every year the prices of commodities and goods are going to increase. This is a given, considering the rising population, dynamic trade, fluctuating economic scenarios, and very limited resources. But at the same time, the government and the central bank of any country has to try hard to keep this rise within the realms of reality. Sharp rises in prices or hyperinflation can doom an economy. To break it down very simply, inflation reduces the value of money. This happens as inflation reduces the purchasing power of a single unit of currency.
The Reality of Inflation
Inflation is not necessarily an evil phenomenon. Usually, anticipated inflation will allow people to plan their investments well, go in for the good investments during inflation, and shield themselves from the rising prices. But unanticipated inflation can give a lot of grief to investors. In most cases, inflation is seen as a sign that the economy is growing. Although, hyperinflation does not mean that the economy is growing rapidly. Inflation within the range of 2 - 4% per year, marks a healthy, growing economy. It is measured using two main parameters, Consumer Price Index (CPI) and Producer Price Index (PPI), which is governed by federal banks. The bank may decide to ease the interest rate to control the liquidity, to suck the money out of the system. The interest rates affect bonds, which are determined by the inflation. So let us look into this relationship in some detail.
Negative Effects of Inflation on Bonds
Any investor investing in bonds is looking at a fixed return after a certain period of time. Say for example an investor invests $1,000 in a Treasury Bill with a 10% yield. That means the investor will get $ 1,100 after one year. If we assume that there is no inflation, it translates into a straight 10% return on his investment. But if we assume an inflation of 4%, which means his purchasing power has reduced, this takes away a chunk from his return of 10%, and now his actual return is only 6%.
This example highlights the need for the investors to look into the difference between a nominal interest rate and a real interest rate. The real interest rate affects the rate of inflation, and hence it needs to be closely followed. Unfortunately, most of the investors look only at the nominal rate and forget about the actual purchasing power.
Relationship with Bonds
Bonds are sold at a premium, discount or at par. When the interest rate or coupon rate of the bond is higher than the current interest rates, it will sell at a premium. When the coupon rate is the same, it will sell at par, and when the coupon rate is lower than the current interest rate, it will sell at a discount. The price of a bond, fundamentally, is the present value of all its future payments. This present value is obtained by discounting the future payments with an appropriate discounting rate, usually the prevailing interest rate. Prevailing interest rate is used as this is the return you get by just keeping your funds in the bank. So usually bonds with a higher rate of return than the prevailing interest rates are sought after.
The main parameters for making the purchase decision of any bond will be the bond price and its yield value. Both these parameters are affected by the prevailing interest rates. A good investment grade bond might turn into a junk bond due to changes in the interest rates corresponding to the inflation.
Another key aspect is the call option that companies have hardwired into their bond. Suppose, due to inflation, the interest rates drop below the coupon rate, the company issuing the bond has to pay more money to the investors. They can simply find a cheaper source for their funds as the prevailing interest rates are lower than the interest that they are paying to their investors. The company may exercise the call option and return the investors their money prematurely, and then borrow from a cheaper source. This drop in interest rate can also be caused by inflation.
These are just some effects that inflation has on bonds. To sum it up, inflation first reduces the effective return on a fixed income or fixed return instrument. It also affects the interest rates which in turn determine the complex bond pricing and yield relationship. Also adverse changes in interest rates caused mainly by sudden unanticipated inflation may cause the companies to call the bonds prematurely, denting the investment plans for many investors who are looking for fixed income, and leaves them adrift.
Careful planning, a little bit of foresight, and a weather eye on the interest and inflation horizon, an investor can effectively plan his bond investments, and even make a neat profit with these ever-changing tides and winds.