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Inflation can affect fixed-income investments when interest rates rise. Central banks frequently set inflation objectives, and if inflation rises above the acceptable level, interest rates may be raised by the officials in charge (Szyszko 288). Investment returns on current fixed-income assets typically drop when they become less competitive than newer, higher-rate fixed-income assets. In other words, interest rates and the prices of fixed-income assets are inversely related. Inflationary effects can also cause damage to fixed-payment strategies. Due to rising inflation, investment returns usually lose purchasing power since most fixed-income investments have the same interest until maturity.
Inflation is a major concern for investors since it harms real savings as well as returns on investments. Investors aim to improve their buying power over time, but inflation gets in the way because investment returns must stay up with inflation in order to increase real purchasing power (Mahlstedt and Zagst 9). An investment that is predicted to return three percent before inflation in a four percent inflation scenario will result in a negative return when accounting for inflation. In situations when investors do not safeguard their investments, fixed income earnings may be harmed by inflation. Many investors purchase fixed-income assets to receive a consistent income stream of interest or coupon payments.
Investors must use short-duration methods to lower interest rate sensitivity to deal with inflation in fixed-income portfolios. Using a short-term approach to reduce a portfolio’s sensitivity to rising interest rates may limit volatility or losses when the interest rates are high (Antonacci et al.1152). The short-term approaches are useful in generating excess returns by focusing on short-dated corporate credit or using a wider set of return drivers as spreads or currencies. The rise of inflation from low levels act as an indicator that the economy is stable. A performing economy benefits corporate credit spreads since defaults are expected to be at low levels.
In addition, Absolute Return Fixed Income (ARFI) approaches provide investors with access to a wide range of global opportunities. When combined with flexible investing tactics, for instance, hedging and a larger focus on alpha to help produce returns, they are expected to negatively correlate with the overall trend of interest rates and credit spreads. ARFI strategies are generally liquid, although they contain a wide range of investment methodologies as well as large disparities in performance among managers due to the breadth and flexibility of mandates (Byström 50). As a result, investors may want to consider implementing a multi-manager approach.
Moreover, transferring a portion of the investment to assets with risk-free coupons can be used to lower interest sensitivity without lowering expected returns. This transfer of investment portions ensures that exposures are appropriately diversified, hence protecting investors in cases of high inflation (Rush 36). Loans as well as securitized assets, like mortgage-backed securities, are illustrations of this. However, investors should be mindful of the numerous dangers of investing in these resources, which are usually considered less liquid as well as sophisticated than traditional fixed-income products.
Many investors, particularly pension plan sponsors, underfunded find the low-yield environment problematic, especially when they need to “catch up” while managing risk at acceptable levels. Pension plan sponsors may face issues as interest rates are likely to rise. By taking a diversified approach to fixed income investing, investors can better manage the risks associated with interest rates as well as inflation and increase the yield in their bond portfolios.
Works Cited
Antonacci, Flavia, et al. “Short-Term Interest Rate Estimation by Filtering in a Model Linking Inflation, the Central Bank and Short-Term Interest Rates.”Mathematics, vol. 9, no. 10, 2021, p. 1152.
Byström, Hans. “Stock Prices and Stock Return Volatilities Implied by the Credit Market.”The Journal of Fixed Income, vol. 25, no. 4, 2016, pp. 32–54.
Mahlstedt, Mirco, and Rudi Zagst. “Inflation Protected Investment Strategies.”Risks, vol. 4, no. 2, 2016, p. 9.
Rush, Stephen. “The Bond Coupon’s Impact on Liquidity.”The Journal of Fixed Income, vol. 27, no. 4, 2018, pp. 34–39.
Szyszko, Magdalena. “Central Bank’s Inflation Forecast and Expectations. A Comparative Analysis.”Prague Economic Papers, vol. 26, no. 3, 2017, pp. 286–299.
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