How inflation impacts your investments

Source: Sun Life Global Investments. *Inflation rates used are hypothetical.

We’ve looked at how inflation erodes your purchasing power. But how will your investments hold up in an inflationary environment? It depends on what investments you’re holding.

Let’s start with bonds, and how they react to inflation. Among the most widely held bonds, are those issued by governments. These are high quality and backed by a low default rate. They’re called investment grade bonds and must carry a BBB credit rating or higher.

These bonds are owned for both the income they produce and their lower risk profile. This is why they’re often held by institutions, pension plans and investment managers to lower risk in their portfolios. For example, traditionally, to offset the risk inherent in equites, a typical balanced mutual fund or ETF would hold 40% in bonds and 60% in stocks.

Nevertheless, returns on bonds can be negatively affected by inflation in a couple of ways. First, depending on the interest rate, if you received an annual payment of $200 a year on your bond, you would be able to buy less and less each year with it. Secondly, these bonds can be hurt when interest rates rise. This may occur when inflation is running above the BoC’s 2% inflation target. To slow inflation, it could force the bank to raise its key lending rate.

It sounds counterintuitive, but when interest rates rise – bond prices fall. Bonds with longer maturity dates (such as a 20-year bond) are particularly vulnerable to rising rates. Why is this? Let’s say your 20-year, $10,000 bond comes with coupon rate of 5% (the coupon rate is the annual income you can expect to receive). The problem is if interest rates jump, new 20-year bond issues coming to market might have a higher coupon rate. If so, new buyers would obviously opt for the higher coupon. This in effect would reduce your bond's value with it now selling at a discounted price.

Alternatively, there are classes of bonds that are indexed to inflation. Two of the most widely held include floating rate bonds and treasury inflation-protected securities (TIPS).

Unlike most bonds that have a fixed interest rate, these types of bonds carry a variable coupon rate. For example, the interest rate on a floating rate bond is tied to a benchmark rate, such as the U.S. Federal Reserve’s (the Fed) key overnight rate. When the Fed rate rises, so will the interest paid on a floating rate bond.

Inflation and stock portfolios

Like bonds, the impact of inflation on your equity or stock holdings depends on how it is invested. Let’s begin by looking at dividend-paying stocks, a source of income for many investors. Dividends are usually paid on a quarterly basis, from a company’s cash flow or profits. And often range from 1% to 10%.

How are dividend payouts affected by inflation? Some companies, such as utility companies, may perform well in an inflationary environment because they can pass rising costs on to consumers. This allows them to increase their dividend payouts to investors. For example, if inflation is running at 3%, and a company increases its dividend to 5%, you could come out ahead.

The opposite would be true if rising costs triggered by inflation force a company to cut its dividend. So again, how inflation affects dividend income comes down to what dividend-paying stocks are included in a portfolio. That’s why managers who focus on dividends put great effort into analyzing a company before they invest. They want to determine whether the dividend being paid is sustainable and whether it may increase or decrease over time. 

Inflation affects growth and value stocks differently

Growth and value investing are two common styles of investing. To understand why inflation affects these stocks differently, remember that inflation erodes the value of money over time. The important issue then is over what time frame is a company’s profitability being calculated. Or more succinctly: profits today could be worth more than potential inflation-eroded profits in the future. 

Let’s begin with value stocks. By definition, these stocks trade at a discount to the market. However, when buying a value stock, the investment manager believes there is a reason that a company might return to, or increase, profitability. And the manager anticipates that this may occur over a comparatively short period of time.

With growth stocks, the opposite is often true. In this case, the investment manager may buy a well-known growth company that is forecasting profits well into the future. Or it may be a company with strong cash flows, even though it could be losing money or have low profits. The assumption being that it might be profitable at some point in the future.

As a result, when inflation and interest rates rise, growth stocks tend to fall. This is because the present value of future earnings is being discounted at a higher rate of inflation.

When inflation is low, growth stocks have historically outperformed value stocks. In periods of rising interest rates and inflation, value stocks may gain ground. In investing, however, past performance is not an indication or guarantee of future performance.

Inflation hedges: commodities and property

As we’ve noted, what’s held in a portfolio will go a long way to determining how it stands up to inflation. When inflation is rising, investment managers may invest in companies such as a utility. Or it could be a company manufacturing an essential product and that can pass rising costs on to consumers. They may also invest in specific asset classes, such as infrastructure and real assets, that have traditionally performed well in an inflationary environment.

Offsetting inflation requires a plan

We’ve shown how inflation can erode your purchasing power. But importantly, it’s what’s in a portfolio that matters when inflation increases. That’s why the best advice is to meet with an advisor. They have the ability assess your finances and suggest investments and strategies that may help offset the risk that inflation poses.