Everything You Should Know About Inflation and Its Impact on Bond Pricing

Friedman knew a thing (or ten!) about the power of inflation to reduce purchasing power, erode real income, and slow down economic growth. These effects of inflation are well-known. But what is not as well-known is how inflation impacts bond pricing and returns.

Bonds are generally considered a safe investment vehicle. But they are not immune to the effect of inflation. Far from it. If you are a new bond investor in India, you should understand what inflation is, its impact on the country, and how it can affect the prices and yields of bonds you plan to buy. This article will help you gain this understanding. 

Inflation and its Key Driving Factors

Inflation is simply the general upward movement in prices of goods and services. Simply put, inflation is the rate at which prices rise and results from excess demand or short supply. In a particular period, increasing prices mean that a unit of currency can buy less than it did in previous periods. In general, high inflation is considered bad for the economy since it leads to a fall in purchasing power, which negatively impacts cost of living and ultimately curtails a country’s economic growth.

Many factors can push inflation rates upwards. One is the increase in the economy’s money supply. India’s monetary authority, the Reserve Bank of India (RBI) can increase India’s money supply by printing more of it or by purchasing government bonds from banks on the secondary market. As more rupees enter India’s economic system, the currency’s value erodes and thus increases inflation.

Currency devaluation can also push inflation up. The lower value of the rupee erodes purchasing power because products cost more. Inflation also increases due to the forces of demand-pull and cost-push. Demand-pull inflation is when the demand for (certain) goods or services is greater than the economy’s ability to meet these demands. Since demand outpaces supply, it puts upward pressure on prices, thus increasing inflation.

Cost-push inflation occurs when the cost of production goes up, thus increasing the final prices of goods and services. Certain government policies can also push inflation up. For example, tax subsidies for certain products can increase demand. If demand outstrips supply, prices will rise.

Finally, inflation can also rise when there is a shortage in supply of essential goods in the economy such as oil, natural gas and metals. When too much money is chasing too few goods, inflation can start to rise rapidly.  

How Inflation Is Calculated in India

Governments measure inflation by comparing the current prices of goods and services to their previous prices. Calculating the inflation rate enables governments to understand the overall impact of price changes on the economy over a specific time period (e.g., a year).

Different sets of goods and services are selected to create a “basket” and track their prices. A price index is then calculated for the basket to indicate inflation. The Consumer Price Index (CPI) and the Wholesale Price Index (WPI) are the most commonly used price indexes.

WPI measures the prices of 697 goods at the wholesale level and shows the combined prices. Comparing the WPI over different periods shows India’s inflation situation. Post 2014, the RBI shifted from the WPI to the CPI to measure inflation. The CPI measures the price change of 260 goods and services at the retail level.

Two items that have a high weightage in both the CPI and WPI are food and fuel. This is because they are both basic goods and therefore play a large role in driving inflation in India. That’s why India calculates food inflation and fuel inflation when calculating inflation.

In June 2022, India’s WPI-based food inflation touched 7.3%, lower than May’s 10.9% but still higher than the 6.3% calculated a year ago. In the same month, India’s CPI-based food inflation was 7.75%. It rose to 8.6% in September and then fell to 4.19% in December, the lowest in the year, prompted by a 15.1% drop in the cost of vegetables. India imports more than 85% of its oil requirement, so rising oil prices directly impact fuel inflation in India. Fuel inflation increased from 31.78% in March 2022 to 50.95% in June, the year’s highest level.

Overall WPI-based inflation in India rose to 14.55% in March, mainly due to rising food and fuel inflation. It came down in the latter half of the year due to falling food inflation (1.07%) and falling fuel inflation (17.35%).

Why Rising Inflation Results in Falling Bond Prices

When prices go up over time (inflation), the purchasing power of each interest payment that a bond makes is eroded. So, if a ten-year bond that pays Rs. 2000 per year will buy less than 10 years from now due to inflation. Such erosion in purchasing power affects investor sentiment because they will worry that the bond’s yield won’t be able to keep up with inflation. As a result, investor demand for that bond will fall, leading to a price drop.

Bond yields rise because bond issuers must pay a competitive interest rate to get investors to invest in their bonds and protect as much purchasing power as they can.

Furthermore, as inflation rises, central banks will increase short-term interest rates to bring the demand-supply situation under control (by increasing interest rates, the central bank will take liquidity out of the system so that too much money is no longer chasing too few goods). But with rising rates, the prices of existing bonds will fall. The longer the bond’s tenor, the more the fall in price. So long bonds will yield negative returns in inflationary scenarios.

Higher repo rates also affect the market value of bonds. The repo rate is the interest rate at which the RBI lends money to commercial banks. The RBI increases repo rates to control inflation, which increases banks’ borrowing costs and affects bond yields.

Example

Suppose a 10-year bond ABC was issued at face value of Rs 100 and an interest rate of 7%. Thus, the bond’s yield is Rs 7. To control inflation, the RBI increases the repo rate, so the lending rate has gone up to 10%. The yield for a newly issued bond XYZ will be Rs 10. Consequently, the demand for ABC will go down since XYZ’s 10% coupon rate promises better returns for investors.

To make ABC more attractive, the bond issuer will decrease its face value to, say, INR 90, so its yield is now 7.77% (7/90*100). This yield is lower than the yield of XYZ but still higher than its original, which makes it more attractive. Thus, an increase in the repo rate increases the yield (directly proportional) and decreases its face value (inversely proportional).

When inflation falls, bond investors worry less about the purchasing power of future bond interest payments. As a result, they may accept lower interest rates, so the prices of older bonds paying higher interest rates will rise.

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