does anyone know how rising inflation rates would effect the price of bonds?
Take a shot, and think it through. Hint: bonds typically have a fixed face value (e.g., $1000) and a fixed interest payment schedule (e.g., 6% of the face value per year), and a fixed maturity date (e.g., 10 years).
So, if there was zero inflation, how much would you pay for a bond that paid $60 per year for 10 years and $1000 at maturity? How much would you pay if you expected 3% inflation?
When considering how rising inflation rates would affect the price of bonds, it is important to understand the relationship between inflation and interest rates.
Bonds typically have a fixed face value, interest payment schedule, and maturity date. Let's use a hypothetical example of a bond with a face value of $1000, an interest payment of $60 per year for 10 years, and a maturity value of $1000.
To determine how inflation affects the price of bonds, we need to consider the purchasing power of the future cash flows. Inflation erodes the purchasing power of future dollars, meaning that the same amount of money will be worth less in the future.
First, let's consider the scenario of zero inflation. In this case, the purchasing power of money remains constant over time. So, you would pay the full face value of $1000 for the bond, as the cash flows of $60 per year and $1000 at maturity would retain their purchasing power.
Now, let's introduce the scenario of 3% inflation. With inflation, the purchasing power of money decreases over time. Therefore, the cash flows of $60 per year and $1000 at maturity will have less purchasing power when they are received in the future.
To account for the decrease in purchasing power due to inflation, investors would demand a higher yield from the bond to compensate for the loss of purchasing power. This increase in required yield is reflected in the form of higher interest rates.
As a result, if investors expect 3% inflation, they would require a higher annual interest rate than the fixed 6% interest payment of the bond. This would make the bond less attractive relative to other investments offering higher yields and become less valuable in the secondary market.
To calculate the price an investor would be willing to pay for the bond with expected 3% inflation, we need to discount the future cash flows by an appropriate rate that reflects the expectations of inflation. The discounted cash flow approach incorporates the time value of money and inflation expectations.
Therefore, rising inflation rates would generally lead to higher interest rates, which in turn would decrease the attractiveness and value of bonds in the market.