I have referred to investment risk very many times in the past. This is a really scary risk in the Indian context NOW, as the inflation rates are sky rocketing.

What exactly is Inflation risk?

Inflation risk is the danger that an increase in price levels (normally for a sustained period of time)  will undermine the purchasing power of a bond’s fixed interest payments. In case of a portfolio we normally try to earn more than the inflation rate.

The Real Return of a portfolio = Nominal return MINUS inflation.

Investors often are attracted to bond (this includes income funds, income opportunity funds, floating rate funds, gilt funds, etc. – normally talking of debt funds with maturity exceeding ONE year) mutual funds because of their regular payouts from interest earnings. These payouts, ARE, subject to inflation risk. Inflation erodes the purchasing power of any investment. It is particularly scary for investments that pay out a fixed stream of interest over a period of time, such as bonds, national savings certificates, post office schemes, and of course the Indian favorite, BANK deposits. As inflation increases the prices of goods and services, investors find that their interest earnings are not keeping pace.

For example, suppose Rs. 10,000 in a bond (remember we are talking of a single bond like State Bank of India bond)  earns 9% interest, but inflation is 8 percent per year. Although this bond will earn Rs. 900 in interest every year, inflation will make goods and services more expensive. Initially, the Rs.500 in interest will buy a certain amount of goods and services (a basket). After a year, that same basket will cost Rs. 972  because of inflation, but the investor will still only receive Rs. 900 in interest income. Year after year as prices rise, the same Rs. 900 in interest earnings will buy lesser and lesser goods and services in the market. This is what is meant by inflation eroding the purchasing power of an investment. The longer a bond’s maturity, the greater its inflation risk. Bond yields often incorporate expectations of inflation so that investors are compensated for expected inflation risk. If inflation rises by more than was expected when the bond was issued, investors will find that the interest and principal returned to them will be worth less than they had anticipated.

So when the market expects higher inflation in the future, the market expects the bond issuer to pay a high rate of interest, for longer duration bonds. So if SBI were to come out with an issue today people WILL EXPECT SBI to pay about 9.3 % interest – simply because the CPI figures are pretty close to this number.

CPI: Consumer Price Index.