Why Deflation is Good for Bond Investors

Deflation is good for lenders. Inflation is good for borrowers. Why? It all has to do with the future real value of money.

If a dollar in the future is worth more than a dollar today, it becomes increasingly expensive (in real terms) to service debt and increasingly beneficial to receive coupon payments. When dollars become more valuable, purchasing power rises. This means you can buy more stuff with the same amount of money. (In reality, most of the time future dollars are worth less than today’s dollars due to inflation.)

Here’s an example: if I’ve lent out $100,000 in exchange for $10,000 annual payment plus principal at maturity, I would prefer those future payments to have greater real value. While I will receive $10,000 in all situations, the value of that $10,000 is affected by prevailing price trends. A deflationary price environment erodes the prices of goods and services, thereby making future dollars more valuable, benefiting lenders.

The following chart illustrates this concept:

If deflation is good for lenders, why wouldn’t banks seek to create a deflationary environment by reducing money supply? While deflation might benefit a single lender, widespread deflation would actually hurt lenders due to greater loan defaults. A deflationary spiral lowers prices, causing companies to cut production and reduce wages. This reduces aggregate demand, further pushing down prices. Asset prices decline are liquidated to cover rising cost of real debt, with many organizations forced into bankruptcy as asset values fall below liabilities.

Beyond this, our entire credit based economy is predicated on growth, of which inflation is a component. A combination of real growth (productivity growth + population growth) and inflation is required to cover aggregate interest costs within an economy. Since real growth is hard to create, inflation is the grease that keeps the economic wheels turning.

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