Ever feel like your investments are diligently working their part, earning regular interest but somehow not keeping up with the inflation? Those interest payouts start feeling like a drop in the bucket. Inflation can take away the purchasing power of your hard-earned returns, leaving you farther from your financial goals than you realise. You carefully chose bonds for their perceived stability and regular returns, but what if you find out that they aren’t providing enough returns, not because of the market volatility but because of the rising inflation? So, does that mean we should stop investing in corporate bonds? Not really. If you really wish to make your investments work for you and safeguard your future wealth, understanding how inflation impacts your corporate bonds is important. We need to understand the impact of inflation on corporate bonds and then how to choose inflation-protected corporate bonds. Let’s dive into how you can protect your bond portfolio from this hidden threat.
How Inflation Affects Corporate Bonds?
Let us first understand the relation between corporate bonds and rising inflation and whether this surge in inflation affects corporate bond yields:
1. Reduction in Purchasing Power:
Let us suppose that the sum of INR 5,00,000 that you invested in 2020 gets you a fixed interest payment (coupon payment) of INR 5000 at regular intervals, but the inflation rate is rising at 6%. The actual value of that INR 5000 in terms of how much you can buy with that amount decreases over time. This means that your real return (which is the return adjusted for inflation) gets lower with the increase in inflation. And if the inflation rate exceeds the bond’s normal yield, then your returns will be negative.1
NOTE: Real Interest Rate is the actual return after accounting for inflation. It provides a more accurate measure of the bond’s true purchasing power. It is calculated using the formula:
Real Interest Rate = Nominal Interest Rate – Inflation Rate. If a bond has a 5% nominal interest rate and inflation is 7%, the real interest rate is -2%.
2. Fluctuation in Bond Prices and Interest Rates:
The relationship between inflation and bond prices is inversely proportional, i.e., when inflation goes up, the banks tend to increase interest rates to control it. So, when the new bonds are issued at a higher rate of interest, the old bonds with lower coupon rates become less attractive, and their market prices start declining.
As a result, these lower-yielding, old bonds can not make their overall yield more competitive with the new, higher-yielding bonds.
NOTE: Overall yield is a measure of the total return an investor can expect if they hold a bond until it matures. It includes the coupon payments and the difference between the purchase price and the face value at maturity.
For example, if you hold a corporate bond with a 5% coupon rate. Now, there is a rise in inflation and the new corporate bonds are issued with a 6% coupon rate. The investors will like to invest in them. To sell your existing 5% bond, you might have to lower its price to make its total return closer to 6%.
3. Increase in borrowing cost:
Investors demand better returns on bonds even during periods of high inflation to compensate for the declining purchasing power of their returns. This puts downward pressure on the prices of old bonds offering lower coupon rates.
It also increases the borrowing costs for the bond issuers, as they will now have to offer competitive high coupon rates on new bonds to attract investors in this inflationary environment.
4. Slow death of longer maturity periods:
Inflation hits harder on bonds with longer maturity periods. This is because over a longer frame of time, there are higher chances of a rise in future inflation rates, thus lowering the purchasing power of the older bonds’ yields. As a result, longer-term bond prices fluctuate in response to fluctuations in inflation expectations and interest rates.
This is how inflation diminishes the real returns of corporate bonds and leads to a decrease in their market prices, especially when it causes interest rates to rise.
Why are interest rates crucial for Bond Investors?
We now know how inflation is impacting the bond yields. But is the rate of interest also important? Yes, indeed! Interest rate movements directly impact bond prices, yields, and the overall risk and return profile of a bond portfolio. Thus, it is important to carefully monitor interest rate trends and understand their impact before making a decision. The following are how interest rates impact bond prices3:
1. Inverse relationship with prices:
When the interest rates go up, the bond prices of the existing bonds fall. And, when the interest rates go down, the bond prices end to rise.
2. Impact on Returns:
Higher interest rates mean higher yields for investors. Thus, low-interest rate bonds that are low-yielding look less attractive to investors.
3. Interest Rate Risk:
If inflation rises and interest rates continue to rise, then investors who invested in the older bonds face the risk that rising interest rates will decrease the value of their bond holdings, especially for longer-term bonds.
4. Risk of Reinvestment:
When bonds mature, investors might have to reinvest the money in new bonds offering lower rates, reducing the overall income generated from the portfolio.
Risks of Corporate Bonds During Inflationary Periods
Next, we wonder what exactly happens to corporate bonds during inflationary periods. The following are the risks associated[2][4]:
- Indian corporate bonds typically offer fixed coupon payments. Given the inflation surge in the country’s economy, the real value of these fixed returns decreases.
- The Reserve Bank of India (RBI) often raises interest rates to control inflation. This makes newly issued bonds with higher yields more attractive, and the prices of the existing corporate bonds with lower yields fall in the secondary market.
- Corporate bonds with longer maturities in India are more sensitive to inflation. Investors see a more significant decline in the market value of these bonds if they need to sell before maturity when interest rates rise. The RBI has started using repo rate adjustments to manage inflation.
NOTE: The repo rate or repurchase rate is the interest rate at which the RBI lends funds to commercial banks against government securities. Changes in the repo rate influence the overall interest rate environment, which in turn affects bond yields. When the repo rate increases, the overall cost of borrowing rises, making bonds with fixed interest rates less attractive, leading to a rise in bond yields and a fall in bond prices.
- Low trading volume, rise in inflation, and the risk of increasing interest rates lead to the investors selling bonds at unfavourable prices.
The Indian government has introduced IIBs (Inflation-Indexed Bonds) that could offer a way to hedge against inflation for risk-fearing investors.
Can Corporate Bonds Outperform Inflation?
Corporate bonds in India offer higher coupon rates compared to government bonds. This makes them a better investment option. While inflation fluctuates, well-rated corporate bonds can sometimes provide returns exceeding inflation. Additionally, corporate bonds can also offer capital appreciation if interest rates fall or the creditworthiness of the issuer improves, adding to the overall return and the potential to outperform inflation. Sometimes, investing in corporate bonds of companies in high-growth sectors of the Indian economy can also give better returns that outperform inflation, as these companies may be better positioned to hedge inflation pressure.
Top Strategies to Protect Bond Investments in 2025
Investing in corporate bonds that give higher yields requires strategic planning while managing risk. Knowing the impact of inflation on corporate bonds, the following strategies can be adopted to protect your Corporate bond investments in 2025:
1. Aligning the duration of your bond investments with your future liabilities is very important. For example, if you are planning to save for retirement, then your choice of bonds must match the time frame. This strategy helps mitigate the interest rate risk because long-term bonds are generally sensitive to interest rate changes.
2. Building a bond ladder helps spread risk and ensures a steady stream of income. A bond ladder stagger the maturity of your corporate bonds while creating a schedule for reinvesting the proceeds as each bond matures. Because your holdings are not stuck in one time period, you reduce the risk of being caught holding a significant cash during any specific inflation period. This is a smart way to diversify maturity distribution.
3. Choose high-quality bonds that may offer lower yields compared to riskier alternatives. This way you get capital preservation without the risk of any default.
4. Rotating your investments across different sectors of the bond market is also a great idea. Study the economic conditions and market trends and capitalize on opportunities in specific sectors while mitigating risk through diversification.
5. Adjust bond allocations based on short-term market opportunities or forecasts. You can smartly choose some short-term, high-yielding bonds that can help you achieve your financial goals quickly. Do not forget, this requires very active monitoring of the market trends.
6. Practice yield curve positioning. Yield curve positioning involves analyzing and adjusting bond allocations based on the shape and slope of the yield curve. Investors may capitalize on opportunities presented by changes in the yield curve’s shape, such as steepening or flattening, to enhance returns and manage risk.
Should You Consider Inflation-Protected Bonds?
Inflation Indexed Bonds (IIBs) issued by the Reserve Bank of India are a compelling option for investors who want to safeguard their savings against inflation. The most prominent benefit of these bonds lies in their principal value and interest payments that are adjusted according to the inflation index, typically the Consumer Price Index (CPI). This ensures that your investment’s value keeps pace with the increasing cost of living, preserving your real purchasing power over the bond’s tenure.
For investors who do not wish to take risks or have long-term financial goals, IIBs offer an assurance of maintaining the real value of their fixed-income portfolio, providing a hedge against inflation.
However, the following things should be considered before investing in any IIBs:
- The stated interest rates before inflation adjustment on IIBs are often lower than the normal bonds with similar maturities, reflecting the built-in inflation protection. Thus, in periods of low inflation, the returns from IIBs might be less attractive compared to conventional bonds.
- The liquidity of IIBs in the secondary market can sometimes be lower than that of other bonds, making it challenging to sell them quickly or at the desired price before maturity.
- IIBs are taxable. Thus, it is important to understand the nitty-gritty of the investment.
Corporate Bonds vs. Government Bonds in an Inflationary Environment
| Feature | Corporate Bonds | Government Bonds (G-Secs) |
| Yield | Higher yields to compensate for credit risk. They may have a better chance of outperforming inflation if the spread is sufficient. | They offer lower yields due to lower risk. They have fewer chances of keeping pace with high inflation. |
| Inflation Risk | Fixed coupon payments lose purchasing power when inflation increases. | Generally offer lower yields that erode further when the inflation rises. |
| Interest Rate Risk | When the interest rates rise, bond prices fall. | In this case, prices fall when interest rates rise. |
| Credit Risk | There is a risk of default by the issuing company, especially if the inflation affects the economy. | Backed by the Government of India, considered comparatively risk-free in terms of default. |
| Liquidity | Lower | Generally Higher |
| Inflation Protection | Most corporate bonds offer fixed payments, providing limited protection against inflation. | The Indian government issues IIBs linked to CPI, offering direct protection against inflation for a portion of the portfolio. |
| Overall Risk Profile | Higher | Lower |
Conclusion
Inflation is inevitable, but smart investment strategies like those offered by Stashfin can help protect your wealth. It is important to manage debt wisely and maintain a balanced bond portfolio to ensure the security of your investment in the future. Spread risk, invest in diverse assets that beat inflation. Get started with Stashfin and make your money work for you!
Frequently Asked Questions
Are Corporate Bonds Safe During Inflation?
Corporate bonds are better than government bonds and comparatively safer during inflation. Inflation generally makes the fixed payments low-yielding and can increase the chances of default in the case of long-term bonds.
Do Rising Interest Rates Hurt Corporate Bond Returns?
Yes, rising interest rates affect corporate bonds. When interest rates go up, older bonds with lower interest rates become less attractive, so their prices often fall.
What Are Inflation-Protected Corporate Bonds?
Inflation-protected Bonds, also known as Inflation Bonds, are a type of government-issued security designed to protect investors from inflation. These bonds adjust both their principal value and interest payments based on the inflation rate, as measured by the Consumer Price Index (CPI).
Is It Wise to Invest in Bonds in 2025?
Yes, if you carefully monitor the market trends. However, it depends on your goals and the overall economy. Bonds can offer stability, but inflation and interest rate changes need to be considered.
How Can I Reduce Risk in Corporate Bond Investments?
Invest in short-term bonds, high-quality bonds, diversify your holdings, and consider actively managed bond funds.