Can I still invest in a period of inflation and rising interest rates?

Rising interest rates and prices may be bad news for bonds, but there are ways to protect your capital in circumstances such as these.

Rising energy prices, shortages in many business sectors, the potential for higher wages – the current environment is ripe for inflation. Certain central banks, which regulate economic activity, are considering the steps they could take to limit the surge in prices. These steps could include raising interest rates, which have been kept at very low levels for over a decade.

However, such rises would have implications for the cost of borrowing as well as the valuation of financial assets in general and bonds in particular, which governments and companies use to finance their activities and development by borrowing money in exchange for a return.

In fact, changes to interest rates have a direct impact on bond values, which fall as yields rise, and inflation will eat into investors’ real returns, since price rises reduce the actual yield on a bond.

So, investors may logically wonder whether it is in their interests to lend their money if real returns, and the value of the securities they hold, are on a downward trajectory. The same question comes up for retail investors with life insurance savings held in euro-denominated funds¹ that invest heavily in bonds.

First of all, there are specific fixed income products such as inflation-linked bonds, which offer investors the advantage of coupons (i.e. interest payments) and a redemption value indexed to inflation. In other words, the interest paid by the borrower, and the capital to be repaid, are tied to inflation, meaning that the investor is protected against price variations.

Moreover, since it allows for opportunities to be identified and securities selected for investment, active management² can help to diversify investments, protect against certain risks, and generate performance.

Active management of a portfolio also allows for what is known as “hedging”. Hedging involves selecting suitable financial instruments – usually referred to as “derivatives” – that can protect the portfolio against, and sometimes even profit from, fluctuations in prices or yields. For example, it is possible to offset the adverse effects of inflation by buying derivatives that take prospective price changes into account.

Investors’ ability to invest their money anywhere in the world means that they can also make the most of differences between geographical regions and/or diversify their risk. Growth momentum can vary widely from one country to the next, so different regions can experience very heterogeneous price and interest rate rises. Meanwhile, companies from what are known as “emerging markets” can offer higher returns because they are deemed higher risk than their European or US counterparts.

¹A euro-denominated fund is a life insurance vehicle that predominantly invests in government bonds. Such funds tend to offer a capital guarantee, coupled with limited returns. As well as euro-denominated funds, it is possible to invest in units of account. These allow investors to use funds to invest in a range of financial instruments (equities, bonds, real estate, etc.), albeit with a risk of capital loss.
²Active management entails selecting the financial assets (equities, bonds, currencies, etc.) that will generate the best performance in relative terms and buying at the right time. By contrast, passive management involves seeking to follow a stock market index