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Inflation is the bond investor's biggest enemy

By David Luhman on Sat, 05/09/2009 - 23:34

Inflation is the bond investor's biggest enemy

So inflation by far is a bond investor's biggest enemy. Conversely, inflation is a bond issuer's best friend. Unfortunately, bond investors run into problems when the largest debt issuer and the one who prints money are the same entity.

The German hyper-inflation

Most people are familiar with Germany's hyperinflation which occurred after World War I. This inflation was instigated by the German government which had war debts to repay. In the hyperinflation of 1923, prices rose by about 10 billion times.

The benefits gained by debtors are easy to see in Germany's hyperinflation. If you're the German government and are heavily indebted, the interest payments alone will swallow all your tax revenues.

Inflation, however, provides an easy way out for you. If this year one mark buys a loaf of bread, but next year it takes ten billion marks to buy that same loaf of bread, a multi-trillion mark debt soon becomes more "manageable" -- even insignificant.

The German hyperinflation was only eliminated when Germany issued a new currency that was backed by gold and with the creation of a new, independent central bank that wasn't a puppet of the government.

The problems with inflation

There are of course, two big problems with governments that think that inflation will bail them out of their problems. First, lenders simply stop loaning money on a long-term basis. No lending means no investment and poor prospects for the economy.

The other problem with inflation is it hurts the weakest people in society. Suppose you're a retired German worker in the early 1920s. You've saved maybe a hundred thousand marks, and between interest and tapping your principal you're able to survive.

Unfortunately, inflation hits and your entire retirement stash of a hundred thousand marks, which took you a lifetime to accumulate, now won't even buy you a cup of coffee!

Things aren't as bad for workers, because their wages are being inflated, but if you can't work, you become completely dependent on the crumbs the government or other organizations might throw your way. As you can see, inflation has severe consequences for bond investors and retirees.

The US and the gold standard

For a long time the ability of the US federal government to generate paper dollars was limited because these dollars had to be backed by gold reserves. While the US was on the classical gold standard from 1880 to 1914 inflation in the US averaged 0.1 percent annually.

But the US began to back away from the gold standard in the 1960s as President Johnson decided to undertake the expensive Vietnam War and the War on Poverty. The United States began to print more dollars than it had gold reserves to back up.

Throughout the late 1960s everyone knew that inflationary pressures were building in the United States. The government maintained that the dollar was as good as gold, while at the same time was flooding the world market with dollars that really weren't backed by gold.

The whole thing fell apart in 1968 when the US government refused to ship gold to so-called speculators at the official rate of $35 to the ounce. Meanwhile, real gold was trading in real markets for $43 an ounce. President Nixon officially rebuked any pretext of a gold standard in 1971 when he said that the dollar would no longer be convertible into gold at any price.

The effects were immediate and obvious. On world-wide currency markets the dollar quickly lost 20 percent of its value, and Nixon had to impose wage and price controls in a vain attempt to stop inflation.

Sell bonds during a war

The inflation that accompanied the Vietnam War is proof that bonds are poor investments during a war.

For some reason, when war breaks out people panic and trade their stocks for bonds. Apparently they think that bonds are safer than stocks. Stocks are generally less volatile than bonds, but buying bonds during a war almost always is a losing bet.

Wars bring inflation, and stocks are the financial assets which are more likely to weather the ensuing inflation. And if you're in an area where the war is hot, think about buying hard assets like jewels which can be smuggled easily out of the country.

The inflationary effects of war can be seen in America. America suffered serious bouts of inflation in 1920, the mid-1940s and the 1970s. These inflationary times occurred after major wars. In fact, the US recorded its highest level of inflation in 1946 when inflation reached 18 percent.

Only strict rationing and price controls prevented inflation from reaching higher levels during World War II. In fact, the rent controls which eventually destroyed large sections of cities like New York got their start as World War II price controls. If you want to buy war bonds, fine, but you'd better write off a good chunk of your investment as a patriotic sacrifice because the war's inflation will eat away at the value of the bond.

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