Inflation brings bond market volatility

Inflation puts many capital investments at risk. Bonds in particular tend to react more strongly to rising interest rates and prices. The higher the inflation goes, the more likely that bond yields will lose value in real terms. This is because bonds are interest-bearing instruments. When you invest in a bond, you are essentially lending money to some institution (a private or publicly traded company, or the government, for example) that uses it to fund its capital needs. You then receive interest in return. Under the terms of a bond, the issuer obligates itself to repay the bond at a predetermined rate of interest (also known as a coupon). As an investor, you are owed the entire principal amount plus the interest when the bond matures. So if you buy a bond with a fixed interest rate of, say, 5 percent, that rate remains the same throughout the life of the bond, regardless of inflation.

Benefits and Risks of Bonds

Although bonds harbor a significant interest-rate risk, they are still an interesting asset class for diversifying a portfolio. They provide a steady stream of income in the form of interest (coupon) payments, usually at a higher rate than money-market investments. Exceptions to this are zero-coupon bonds and short and medium-term bonds used by governments for financing, especially national governments (with bonds known as treasury bills). With these, the interest yield is deducted from the purchase price, and investors get the full face value of the bond back at maturity. For example, a bond with a total volume of 10 billion euros is issued in pieces (called partial debentures) of 1.000 euros each. This amount is the face value of the bond. At maturity, investors get 1.000 euros back for each partial debenture they have purchased.

Interest rate changes can affect the value of a bond. When investors hold bonds to maturity, they receive the face value plus interest. If investors sell an exchange-listed bond before maturity, what they get back is the current market value, which is not necessarily the face value of the bond. This is because when interest rates rise, bond prices fall. When interest rates fall, bond prices rise. In periods of rising interest rates, newly issued bonds are attractive to investors because they offer higher coupon payments. For an older bond with a lower interest rate to be sold, it may have to be sold at a discount. Longer-term bonds tend to be more sensitive to changes in central-bank interest rates than their shorter-term counterparts. Then there is also the risk that the interest or coupon can no longer be serviced.

All bonds have credit risk. The risk is that an issuer will default on one or more payments before the bond reaches maturity. In this case, investors may lose some or all of their return, and potentially the entire amount of capital they invested.

To measure credit risk, many bonds are rated by independent rating agencies. The best known are S&P, Moody’s, and Fitch (all three American and often called the Big 3). Their rating systems are different. At S&P, for example, the ratings go from AAA (highest creditworthiness, very high interest, and repayment capacity, lowest risk of default) to D (inadequate creditworthiness, interest, and repayment partially or completely stopped, eligible for bankruptcy proceedings).

What types of bonds are there?

Bonds can be put into different categories:

• The biggest distinction is made between government and corporate bonds. These two categories include German federal securities, EU government bonds, government bonds from other countries, corporate bonds from German or international companies, and covered bonds from banks or mortgage institutions.
• If we categorize bonds by type of interest rate, there are fixed-rate bonds, floating-rate bonds, low-yield bonds, and zero-coupon bonds.

Assessing the Current Situation

For bonds, we expect a higher range of fluctuation (volatility) in the short term, since current inflation rates and restrictive monetary policy will continue to cause uncertainty. Although the capital market has already mostly priced in the interest rate changes that have been completed or announced, it will continue to wait for the first signs of slowing inflation and a resulting turnaround in interest rates.

Interest rates on corporate bonds have already increased significantly based on higher credit risks, but reassessments will depend on recession risks. These risk premiums could further increase in the event of a deep recession. On the positive side, we note that we have not seen any sudden increase in payment defaults.

If you would like more information or have any questions about bonds or other asset classes, our portfolio manager Julian Bösch will be happy to provide you with non-binding information.