2. Inflation Risk
The other risk which is, tied to the hip of interest rate risk is inflation. Kenny (2020) describes inflation as “the general rise in the prices of goods and services.”.It is also known as a loss in the purchasing power of the dollar. He says that inflation is correlated with interest rate because as inflation rises, the interest rate goes up, which in turn makes bond prices fall due to its inverse relationship, as mentioned earlier. Kenny (2020) believes that inflation will always be a silent thief eating away into your returns. Buffet (1997) elaborates on this point by telling investors about the necessity to obtain a return on your investment that equals the effects of inflation. She gives us an explanation by telling us to imagine that the inflation rate is 5 percent or, in other words, your money depreciates at 5 percent. Thus, you would need to obtain a 5 percent return from your investment just to offset* the inflation effects, or otherwise, you would lose your purchasing power and, as a result, create no wealth. Buffet (1997) quotes Graham (1949) who said, “common stocks are by no means an ideal protection or ‘hedge’ against inflation, but they do more for the investors on this point than either bonds or cash”. In other words, he succinctly said that bonds are more prone to the risk of inflation compared to other asset classes such as stocks. His advice is still accurate and applicable to this day, as Blanchett (2020) says that with government bonds currently yielding around 0.6 percent and inflation at 1 percent, bond investors would be losing their purchasing power by 0.4 percent, or put simply you are losing your money by 0.4 percent.
*In addition to inflation effects, you need to also offset your taxable income. Essentially this means you need 5%+1.55%=6.55% to break even. (5*31%=1.55%)