Why you must pay attention to the real interest rate of bonds

Julie Brownlee, Fsp Invest, 24 Feb. 2015

Tags: bonds, interest rates, real interest rate, nominal interest rate, interest rates and bonds, inflation-linked bonds

One of the main reasons investors buy bonds is to secure a regular income.

Bonds pay a fixed interest rate for the duration of their life.

While this gives you peace of mind as you know how much you’ll receive in income, the interest rate you receive is vulnerable to soaring inflation.

Let’s take a closer look…

Bonds tend to quote nominal interest rates

When you buy bonds, you’re essentially lending the bond issuer money.

In return for lending to the issuer, you receive interest payments until the bond matures. This is usually twice a year.

Unless you buy inflation-linked bonds, you need to be aware of the impact of inflation on your income while you’re a holder of bonds.

And that’s why you need to pay attention to the real interest rate and not the nominal interest rate. So what does this mean?

When you look at the interest rates payable on bonds, unless it’s an inflation-linked bond, it will be the nominal interest rate. That means the interest rate doesn’t take inflation into account.

Work out the real interest rate payable on bonds

So what you need to do is calculate the real interest rate. The real interest is the nominal interest rate minus the rate of inflation.

The problem you face when you invest in bonds is the length of time until it reaches maturity. The longer this is, the higher the risk of inflation rising. And rising inflation easts into your interest income.

Generally speaking, the longer it is until a bond matures, the higher the rate of interest paid. This is to compensate for the additional risk you take on buying a bond with a lengthy maturity.

Since the financial crisis of 2008, interest rates are at historical lows. This has negatively impacted the income of bonds as inflation hasn’t fallen by as much.

If the rate of inflation exceeds the interest rate payable, you’re essentially losing money. If you’re worried about the future impact of inflation, opt to buy inflation-linked bonds.

So there you have it. Why you must pay attention to the real interest rate of bonds

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