What is inflation risk and how do you mitigate it?

What is inflation?

Inflation is the lessening of money’s purchasing power in an economy. Through inflation, the cost of consumer items and services rises – meaning your money is worth less than it used to be. This weakens a currency as each pound buys you fewer things than before the rise in inflation.

Inflation is usually measured within a country – the term for this is ‘headline inflation’. Two acronyms are associated with headline inflation: CPI (Consumer Price Index) and RPI (Retail Price Index). CPI refers to the current price of consumable goods in shops, while RPI is slightly broader and also refers to other costs of living you won’t find in stores, such as property prices, mortgage interest rates and more.

CPI and RPI are by far the most commonly used terms when speaking about headline inflation, although other inflationary indices exist.

Because inflation makes money worth less, it’s problematic for any non-inflation linked investment as it lowers the real value (ie the purchasing power) of those returns.

What is inflation risk?

Inflation risk is the possibility that unexpected inflation will significantly erode the real value of the returns you’d get from an investment.

With higher inflation, you may still get future income from an investment, but what that money can actually buy is diminished because the cost of living has risen – even if the monetary amount hasn’t changed.

This is especially worrying for investors in fixed-income assets like bonds, where coupon amounts remain consistent but their real value declines.

Inflation risk: an example

Let’s say you buy a bond with a coupon rate of 3%, which is a normal, nominal amount when you invest in the bond. However, if the inflation rate is 2% at the time, your purchasing power is only really increasing by 1%. This is your real return.
In its most basic form, the formula for calculating your real return is:

Real return = nominal return − inflation

Because bonds are fixed-income assets, your coupon rate won’t change with time, even if the inflation rate does. So, if the inflation rate climbs above 2%, it’ll erode the value of your bond even further. In a worst-case scenario, your real returns could even become negative. Say, for instance, the nominal return is 3% but inflation is sitting at 5%:

3% nominal − 5% inflation = −2% real return

Here, your investment is actually losing you money, even though your nominal return (3%) hasn’t changed.

What is an inflation risk premium?

An inflation risk premium is the amount a lender will pay to the investor to compensate them for taking on inflation risk. This premium increases the returns an investor might see on fixed-income assets in a time of inflation hikes, making them more attractive.

Inflation risk vs interest rate risk

Inflation risk and interest rate risk are sometimes confused, as they’re closely related in the bond market.

• Inflation risk is the chance that your return from an investment (eg bond coupons) can lose value in real terms due to a rapid inflation rate
• Interest rate risk is the chance that the value of an asset (like bonds) can decrease due to increasing interest rates and a hawkish environment

Rises in inflation are often followed by increases in interest rates. That’s because central banks, like the Bank of England for example, often hike interest rates to discourage cash-strapped consumers from spending too much on credit when inflation makes prices increase.

Due to this, bond prices and interest rates are inversely related – when interest rates rise, bond prices fall, and vice versa.
If you decided to sell a bond on the secondary market at a time when the rate of interest had risen significantly, you’d receive a price lower than the bond’s face value if its coupon is lower than the current interest rate.

On the other hand, an increase in the inflation rate would mean that each coupon payment made by the bond would be increasingly less valuable to a bond holder. That’s because the bond’s real interest rate would have been lessened.

How does inflation affect investments?

Inflation doesn’t affect all investments the same way. Asset classes that don’t adjust their returns in line with inflation are exposed to inflation risk. These include fixed-income bonds, stocks and even savings deposits.

There are also assets that’ve historically protected against the negative effects of inflation. These include commodities, index-linked bonds, REITs (real estate investment trusts) and also, over the longer term, a well-balanced and diversified shares portfolio.

Let’s have a look at how inflation hikes tend to affect some of the most popular markets.

Bonds and inflation risk

As we’ve discussed earlier, coupon payments are a fixed amount, and so become worth less as inflation increases. The more rapid the rise of inflation, the faster those coupon payments lose value in real terms for investors, even if they don’t technically have a diminished rate of return.

Learn more about how to trade or invest in bonds

Stocks and inflation risk

There’s no hard and fast rule regarding how inflation may affect a share’s price, because there are a wide range of industries and companies out there, which will react to the same environment in diverse and different ways. Each stock should be judged on its individual merits. However, a few guidelines are worth knowing:

• Growth stocks tend to decline in price during high inflation periods and their promise of future appreciation becomes less attractive when inflation lessens the value of those potential returns
• Income stocks pay regular and stable dividends, which may not keep up with inflation in the short run, so their price could decline in a high inflation environment until dividends rise
• International stocks may experience a falling share price, if competing in global markets or against foreign companies in local markets, during periods of high inflation. Yet, if the company raises prices too much, it runs the risk of becoming uncompetitive
• Value stocks are often preferred by investors when inflation is high. That’s because they have a higher intrinsic worth than their current trading price and are frequently usually well-established, mature companies characterised by strong cash flow
• Defensive stocks usually retain their value during periods of high inflation, as consumers will still buy from them when times are tight. They are often used as a hedge against weak macroeconomic conditions, but could underperform in positive markets

Savings deposits and other cash investments

During periods when investors are feeling squeezed, cash investments like savings deposit accounts and other cash deposits tend to be popular. So, do they do well during higher inflation periods?

Cash-based investments, like cash deposits or savings deposit accounts, are very liquid. They aren’t vulnerable to many of the other risks, like excess volatility, that other asset classes face during times of financial upheaval. As the saying goes, a pound is a pound no matter what the market’s doing.

However, they are very much exposed to inflation risk – in fact, cash is one of the most affected markets when inflation rises, because it erodes the very value that that pound has. If inflation increases significantly or unexpectedly, the real value of your deposits decreases if it isn’t earning above-inflation interest. This would result in a negative real return.

Plus, this inflation risk also applies to other, less liquid cash investments like certificates of deposit and money accounts.

How to hedge against inflation risk

Real Estate Investment Trusts (REITs)

• Because the price of property and mortgages almost always go up when inflation does, REITs perform well during times of higher inflation
• Gaining exposure to REITs can provide a natural hedge against inflation in this way
• With us, you can buy shares in popular REIT ETFs, like the Vanguard REIT ETF and the iShares Global REIT ETF. This means you’ll be able to invest in an ETF that gives you broad exposure to the REIT market with a single position

Gold

• Traditionally, gold is viewed as a hedge against inflation and tends to do well during times of aggressive hikes
• The fact that many view gold as such will, more often than not, boost its prices during any period of uncertainty, making it a valuable hedge
• Owning gold outright can be a complex process, but with us you can trade on gold as a commodity, as well as on gold-exposed companies such as miners. This means you won’t take possession of any physical gold but can instead make a profit or a loss by predicting the movement of the underlying gold market you’re trading on

UK index-linked gilts

• If the inflation you want to trade is global in nature, you can also trade UK index-linked gilts: a bond issued by the UK government designed to combat inflation
• Index-linked gilts are supposed to have coupon payment amounts that rise when inflation rises, ensuring that an investor’s final settlement repayment matches the accrued inflation amount over the years that bond has been held
• This means that investments generally do better in a higher inflation environment, so they can be used to hedge against other asset classes more vulnerable to inflation

Treasury Inflation Protected Securities (TIPS)

• Similar to UK index-linked gilts, TIPS are the American equivalent, issued by the United States Treasury
• TIPS are benchmarked against the US Consumer Price Index (CPI), so when the cost of living rises due to inflation, so does the value of a TIPS bond
• This means these, too, can provide protection against rising inflation

Long-run stock portfolio

• Over time, stock prices, dividends and earnings stabilise at a new, higher level
• This will conserve the real value – ie the purchasing power – of a stock over the long term
• This means that, while stocks may depreciate during higher inflation times temporarily, they can also be a valuable hedge against it in the longer term

How to trade or hedge inflation with us

With us, you can speculate on or hedge against inflation in two ways: investing and trading.
Follow these steps to take a position:

1. Research your preferred market
2. Decide whether to invest or trade
3. Open a live account or practise on a demo
4. Take steps to manage your risk
5. Select ‘place deal’ and monitor your position

Investing for inflation risk

You can invest with us via a stock trading account. You’ll take ownership of shares or ETFs that are resistant to the negative effects of inflation – for example defensive stocks, REITs ETFs or commodity ETFs. You’ll also make a profit if what you’ve purchased appreciates in price and you then sell your shares or ETFs for a higher price than you initially paid for them.

Trading for inflation risk

When trading, you won’t own any shares or ETFs outright, but will instead speculate on the price of stocks, bonds, commodities or any other market you think will do well against inflation.

You can do this using a CFD trading account.

As a trader, you’ll take a position on the performance of the underlying market during inflation – such as government bonds, futures, gold and more – going long if you think the market’s price will rise and going short if you think it’ll fall. You’ll make a profit if you predict this correctly, and a loss if you don’t.

To trade international inflation, you can also take a position on either UK inflation or US inflation using an inflation index. This allows for hedging against losses on current bond and shareholdings, and can be used by traders to take a view on inflationary movements.

Inflation risk summed up

• Inflation is the decreasing of money’s purchasing power
• Inflation risk is the chance that inflation will lessen the purchasing power of your investments over time
• Different types of assets react differently to inflation. For example, REITs tend to appreciate in value when inflation rises, while cash is vulnerable to inflation risk
• With us, you can trade on inflation, as well as hedge against inflation via investing or trading
• You can invest in inflation-exposed markets using a stock trading account or trade inflation using CFDs

Footnotes
¹ Based on revenue excluding FX (published financial statements, October 2021)