Inflation and Bonds

Bonds do not generally work well in an inflationary environment. When inflation rises, interest rates also tend to rise. Unfortunately, rising interest rates mean that existing bond values decline. This occurs because an investor can now get a higher interest rate on a new bond than on an older bond. To offset this difference, old bond prices are discounted (reduced) to give investors the same basic rate of return on either old or new bonds. The longer the time to the maturity of the bond, the greater the discount tends to be in the reduction of the bond’s price. This is an area that I have been watching carefully for the past year. In 2009, we were fortunate that interest rates decreased and the value of the bonds increased. This year, it has been a bit of a seesaw, with interest rates fluctuating within a fairly narrow range. In this environment, we have been looking toward moving from very short maturities (60 days to two years) with very low interest to the higher interest on longer-term bonds (average maturity of 4 to 5 years). My confidence in this position comes from seeing core inflation remaining reasonable and consistent. This consistency in the inflation rate should lead to consistent interest rates on longer-term bonds for the next several quarters. The bad news is that the current control of inflation appears to be in large measure because of continuing unemployment and growing layoffs. Overall, the bond market likes stability, and even with the massive federal bond offerings, bonds do seem to be stable. Ed Mallon