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Bondholders' Biggest Threat? It's Not the Fed

Rising interest rates will temporarily hurt bond returns, but high inflation is much more damaging to bond portfolios.

Bondholders' Biggest Threat? It's Not the Fed

Tim Strauts: With the Federal Reserve likely to raise interest rates in the next several months, investors have been concerned about a potential decline in bond performance. In general, bonds tend to perform poorly in times of rising interest rates; but by worrying about rates, investors may lose sight of an even bigger long-term threat: inflation. In today's chart, we are going to explore how inflation hurts returns over the long term.

Since 1926, five-year U.S. Treasury bonds have returned 5.3% annually. One dollar grew to $99 in that period. But when adjusting the returns for the effects of inflation, investors only earned 2.1% annually. That may not sound too bad until you realize that $1 only grew to $7 on an inflation-adjusted basis. The effects of inflation ate 93% of the cumulative return.

In periods of high inflation like the 1970s, the situation gets even worse. From 1970-80, five-year Treasuries returned almost 100% on a nominal basis. However, when adjusting those returns for inflation, investors actually lost money over the decade. While many fixed-income investors may wish for the high yields of the 1970s to return, they probably don't realize, on an inflation-adjusted basis, today is a better environment for fixed-income investors. While yields are low, they are still above the rate of inflation, which has been running close to zero over the last year.

In conclusion, rising interest rates will temporarily hurt bond returns, but higher rates give investors the opportunity to earn higher income on new bond purchases. High inflation is much more damaging to bond portfolios, with no upside to investors.

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