 Hello and welcome to the session in which we'll discuss the effect of inflation on debt investments and debt What is inflation? Inflation when the prices the general prices of goods and services? increases as a result inflation will erode would reduce the purchasing power of money over time But the question here is when that purchasing power is reduced when we have inflation how does that affect that investment and And if you are holding debt So the inflation can have a varying effect on that investments and when we say that investments for simplicity We're gonna assume bonds, but bonds is not the only form of that investments You can have bonds you can have fixed annuity payments You could have all sorts of contract where you are receiving a fixed amount of money, which is similar to a bond and That debt is basically when you borrow money So it will have a varying effect on that investments and that those are two separate topics So here's the bond and Here's the person carrying the debt it depends on the type of the investment and the terms of the debt We're gonna see the investment could have a fixed rate investment fixed rate means the coupon on these bonds are fixed If they promise you six percent on this bond, they will always pay you six percent Or you could have a bond where the where the rate is a floating rate floating means it's gonna change It's structure to adjust interest rate periodically based on a benchmark For example the LIBOR benchmark or the government yield along the interbank offering rate What does that mean? It means if inflation goes up by one point So rather than earning six percent now They add one percent to your bond and you will earn seven percent and the same is true if inflation goes down by one percent You would rate is five percent. So depending on the type of the bond you are carrying You could also have fixed rate debt For example, you might borrow money and the rate is fixed and we're gonna look from a lender's perspective and the borrower's Perspective also, you could have a floating grade that you could borrow money and your rate on that debt is floating It changes we're gonna look at it from a lender's perspective as well as the borrower's perspective Let's go ahead and to start to discussing the fixed rate Investment fixed rate debt investments before we proceed any further. I have a public announcement about my company farhatlectures.com Farhat accounting lectures is a supplemental educational tool That's gonna help you with your CPA exam preparation as well as your accounting courses My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of Lectures, multiple choice questions, true-false questions as well as exercises. Go ahead start your free trial today Well What we're looking at here are bond and similar instruments to bond. Similar instrument means any Instrument that's gonna pay you a fixed amount of money over time Plus it will pay you your principal the original amount. So any investments could be an annuity It could be bonds but bonds are most common. So with fixed rate debt investment It's gonna give you a pre-determined interest rate 6% so when inflation rises the future value of the fixed interest rate payment May decrease in real time. So for example, you invested a thousand dollar or a hundred thousand dollar and You are receiving per year six percent. So you are receiving per year six thousand dollar and This rate don't change because it's a fixed rate now the six thousand dollar for the sake of illustration again I'm gonna assume we are buying cups of coffee and we're gonna buy a lot of coffee So let's assume per year you consume three thousand cups of coffee Well, because the cup of coffee is for two dollars. So you could use the six thousand dollar and buy three thousand cups of coffee now, let's assume This is year one in year two we have inflation you are still receiving six thousand dollar now the cup of coffee is three dollars Then you could only buy Two thousand cups. So what happened is the real value of the six thousand went down So when inflation rises to new bonds issued in the market tend to offer a higher rate So you have a bond that's paying six percent now in year two interest rate went up The new bonds are paying eight percent or ten percent No one wants to buy your bond even if you want to sell it. No one's going to buy your bond Therefore your bond would lose value your bond would lose value the existing bonds with lower fixed interest rate becomes less attractive leading to a decrease in The market value now the opposite is true every everything I see about inflation going up the opposite is true If inflation decreases the value of the existing bond Let's assume now the new bonds are only paying four percent but yours is paying six and everybody wants to buy your bond The bond value will go up Well, you need to know is this overall as inflation increases the real return on these investment decreases So when inflation goes up and you're still getting the six thousand the six thousand is buying you less Therefore your purchasing power is reducing this means that while you're still receive the fixed interest payment of six thousand The purchasing power on of these payments may decline now they pay you they buy you only two thousand cups of coffee So this is the fixed debt investment. Well, guess what you could have a debt investment But you could structure it in a way where the interest rate is a floating it changes it floats Floating typically have interest rate that reset reset means changes periodically every three or six months So if inflation increases the rate on these investments would rise as well Because they are linked to some sort of a benchmark either the LIBOR or US Treasury So if the overall interest rate in the economy increases, well, guess what? What they pay you on this bond also goes up and this adjustment Mechanism will help you to mitigate the inflation effect on your real return So if they're paying you six interest rate went up now, they're paying you one additional percentage They're paying you seven. Well, yes everything up went up in value, but rather they're getting the six thousand now You got seven times you're gonna be getting seven thousand. So it will mitigate that increase in rate some floating Rate that are specifically to protect you against inflation. For example in the US We have something called the Treasury Inflation protective securities or for short, they are called tips their whole purpose is to is to Adjust the value of the investment to protect you from inflation But bear in mind if inflation goes down your your real return would also go down as well So tips have their principal value adjusted based on the changes in inflation Ensuring the real value of the investment remained stable relatively stable. So this is from the investment perspective now Let's talk about From the debt, how does inflation? Effect the debt that means when you borrow money, let's talk about new borrowing Well, if we have inflation as we said when inflation kicks in the Federal Reserve increase the interest rate What's gonna happen to the borrowing cost the borrowing cost? So if you want to borrow money now the borrowing cost is higher So inflation can increase the borrowing cost for individuals businesses and government So it costs more money. It costs more money to operate when inflation rises Lenders typically demand higher rate of return to compensate Because lenders especially the longer they want to lend you the money the higher They want to return because they want to protect themselves So this means borrowers may face a higher interest rate expense when taking a new debt or refinancing an existing debt So as a result the cost of servicing the debt will put pressure on the borrowers finances Assuming again, this is a new loan now from the lenders perspective lenders are happy to lock higher rate on new debt So if the interest rate went up, they would rather charge you the newer higher rate so they can lock it How about if you already have an existing debt an Interest rate went up inflation went up if inflation increases the value of the outstanding debt decreases why? Because let's assume you borrowed one hundred thousand dollar at six percent now You are the borrower you have to pay per year. You have to pay per year pay $6,000 per year on this debt Now let's assume you were making is for the sake of illustration $70,000 per year when you took this loan now when when when inflation kicks in when inflation kicks in your company raised your rate by By $5,000 so the company says, you know what since inflation is here. We're gonna raise your rate by $5,000 So notice here because of the inflation You increased your income by $5,000 to compensate for the higher Higher cost of living however your debt the $6,000 debt it did not change Therefore you can take this $5,000 that they gave you as extra money and pay off make make your payment And you'd like great. I'm not really, you know I got extra money to pay the debt and who knows they might increase your salary to 80% to compensate for Inflation and your payment will stay the same That's so if you have debt and Inflation kicks in and your payment is fixed then you should be in good shape You should be in good shape So the fixed amount of that remain the same in nominal terms, but in real terms it decreases This can be advantageous to the borrower as the repayment is worth less in real term however Who's gonna be affected the lenders the lenders bear the loss of the purchasing power Because the lenders now the people that lend you the money you're paying them $6,000 But you should be paying them more but since the debt is fixed however if inflation outpaces Wait wage growth or income increases then you're in trouble. So if the inflation If your wages are not increasing with the inflation Then guess what it didn't really help you because the assumption is you're getting more money more nominal money To pay a fixed amount if that's not the case then it's not beneficial now bear in mind if you have a variable rate The lender is protected. It means your payment goes up the lender is protected. Let's talk about few Investments that are considered inflation protected. Now. What is inflation protected investment? Any investment that changes in value with inflation is inflation protected? Okay, what could be what could be some some of those? Historical historically Inflation protected investment if you buy gold silver metal oil they historically work as a hedging against inflation So investing in commodities in general can provide a way to preserve value during inflation because what happened is this? Gold will go up silver will go up all the metal will go up Because the prices of things went up and those are actual real things Also real estate if you have a building and you rented that building so the building itself It will go up in value because the price of everything went up and you have that real asset also of that building generate income and You can increase your rental income assuming you can increase your prices then you are protected. You are protected livestock cows any sorts of livestock they also go up in value because They need the consumers. They will need to pay higher prices any agricultural product also given everything else equal It should go up in value because if you go to the store to buy tomatoes potatoes bananas anything you want to buy It goes up during inflation. It means also the producer Raised the price as well to keep up with inflation. No inflation is not good, but at least they are protected So simply put any anything that increases in value Proportionally or faster than inflation is inflation protected What should you do now go to far have lectures look at additional mcqs? That's gonna help you practice what we just learned Practice what we learn means apply what you just learned. Okay. You understand it. That's great But what you want to do you want to learn it by practicing invest in yourself? Invest in your CPA exam. Good luck study hard and stay safe