Money Monday: Bonds, Inflation and YouOctober 8th, 2012 by Aaron Koo
While equity gets us the overall growth we need to save for the long term by investing in companies, fixed income is meant to provide us with a more secure, lower gains void of the volatility that comes with investing in the equities market. While fixed income investments are very secure, oftentimes “guaranteed,” people have little understanding of the nuances of this and how it actually impacts their portfolio.
How Do They Work?
For the sake of this article, I want to focus on government bonds. A bond anywhere, whether it be a government bond or a corporate bond, is a debt.
A government or a corporation will issue a bond to help pay off a debt by taking your money for a fixed period of time, investing it to pay down their own debt, and then returning your capital with a modest gain. Since government bonds are invested very conservatively, they’ve had a reputation of yielding small but very secure gains. Canadian savings bonds, for example, are considered to be virtually guaranteed and the very best worldwide.
What’s Inflation Got To Do With It?
When investing in bonds, or any other fixed income investment for that matter, the idea is to preserve capital when you are close to your financial goal. If you wanted to save $100k for a home if you were at $99k, you wouldn’t want to take on any more volatility than necessary.
A common strategy is also to invest in fixed income to ensure that inflation doesn’t eat away at the buying power of your money. There’s a problem with this. When I said that government bonds are virtually guaranteed, they essentially are. When the government invests money poorly and sees negative returns, they can at the very least return the capital and the guaranteed interest in terms of your dollars. The way they do that is by having the federal reserve print more money. There’s another problem with this.
Printing money creates inflation. Inflation weakens the buying power of your dollar. See the problem? All the time spent in bonds–or any “guaranteed” investment for that matter–is actually counter-productive since it’s accelerating the inflation which is precisely what you’re trying to avoid.
What Can I Do?
There’s really nothing you have to do. Bonds aren’t bad. People just need to be aware that, while very secure, they’re not void of volatility. Just have a look at what’s happening worldwide today. Bonds from every government are collapsing. Pensions are being dried up.
This is the risk we all take when we invest our money, a very necessary risk for most. Most people aren’t willing to do what’s necessary to accumulate wealth on their own and thus have to put their trust in investments to get to where they need to be. It’s a scary thought when you look at what’s happening to bonds around the world but unless you have millions in assets sitting around, you need to trust in the potential of investing your money.
Filed under Money.