Rising consumer prices means that the real value of a bond's fixed payments will be gradually eroded, and this can have a significant cumulative impact over a period of several years. Conventional bonds with a long time until final maturity can therefore be highly vulnerable to a loss in value due to rising inflation.
Bonds can also be affected by a rise in the expected level of inflation in the future, even if there is no change in current inflation. If inflation is expected to rise in the future, fixed income investors will typically demand a higher yield as compensation. For these reasons, it is imperative that fixed income investors have a clear understanding of how inflation can affect bond markets and to be able to position their fixed income portfolios accordingly.
For those concerned about a future rise in inflation, index-linked bonds effectively hedge away this risk by delivering returns that are adjusted in line with the RPI. However, when investing in these instruments, it is important to consider not only where inflation is going, but also how much inflation is being priced in. Index-linked bonds may be cheapest when inflation expectations are most subdued, although markets are forward-thinking and can react quickly - inflation protection could well become a lot more expensive before inflation actually starts to rise.