Inflation: The hidden risk in bond investing

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OPINION

By  Robert Katuntu

There is a clear and growing appetite among both institutional and retail investors for Government of Uganda (GoU) bonds. These securities continue to attract strong demand owing to their competitive coupon rates, the near risk-free credit profile underpinned by sovereign backing, and the preferential tax treatment available on longer-tenor instruments.

Collectively, these attributes make GoU bonds a compelling option for investors seeking stable returns, predictable cash flows, and portfolio diversification within Uganda’s capital markets. That said, seasoned investors recognise that there is no such thing as a “free lunch.”

While GoU bonds offer attractive nominal yields, investors must account for the erosive effect of inflation on future cash flows. Inflation, simply defined as the sustained increase in the general price level, diminishes the purchasing power of both coupon payments and principal redemption. For example, an investment in a 10-year GoU bond will not retain the same real value at maturity; the purchasing power of that sum will be lower after a decade of inflationary pressure.

A further limitation of fixed-income instruments is the absence of capital appreciation. Unlike equities or real estate, which can generate both income (dividends or rent) and capital gains, bonds return the original principal at maturity alongside periodic interest. Thus, bond investors rely solely on income returns, without the upside potential of asset price appreciation. To illustrate, consider an investor purchasing a 10-year GoU bond with a 15% coupon at sh10 million, assuming average inflation of 5% per annum over the holding period.

Applying the standard present value formula ((FV / (1+i)^n)), the sh10 million principal will have an inflation-adjusted value of approximately sh6.1 million at maturity. This represents a 39% loss in purchasing power on the principal alone.

Fortunately, the semi-annual coupon payments help offset this erosion, provided the nominal coupon rate remains above the inflation rate.

In conclusion, investors should look beyond the headline coupon rate and incorporate inflation-adjusted metrics when evaluating GoU bonds. This introduces the concept of the real rate of return, calculated as the nominal coupon rate less the inflation rate. In the example above, the real return is approximately 10% (15% coupon minus 5% inflation), underscoring the importance of distinguishing between nominal and real yields in fixed-income portfolio construction.

The writer is a partner at J. Samuel Richards & Associates, Certified Public Accountants