Investments : Effect of Inflation and Deflation and Types of Annuities

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1. Inflation is the increase in the price of products over time. Inflation rates have fluctuated over the years. Sometimes inflation runs high, and other times it is hardly noticeable. The short-term changes aren't the real issue. The real issue is the effects of long-term inflation. Over the long term, inflation erodes the purchasing power of your income and wealth. That means that even as you save and invest, your accumulated wealth buys less and less, just with the mere passage of time. And those who put off saving and investing will be even deeper in the hole.

Deflation turns everything about investing on its head. Most particularly, it makes Treasury bonds extremely valuable. A T-bond makes fixed interest payments year after year.

In inflationary times, fixed payments buy less each year. But in deflationary times, fixed payments are worth more every year. The purchasing power of $100 in 1930 rose to $122 by 1935. When investors think deflation is coming, they buy Treasuries. They don't rush to corporate bonds, however. Deflation makes debt payments more onerous each year. Treasuries are backed by the government, which can print more money if it has to. But in severe deflationary times, companies tend to go bankrupt, leaving bond investors in the lurch.

Deflation pushes interest rates down. Deflation-minded investors are so eager to buy Treasuries, they happily accept lower rates. They also push up the prices of existing Treasuries. This pushes their yield — interest payment divided by price — down. For example, if you pay $1,000 for a Treasury bond with a $50 interest payment, its yield is 5%. Push the price to $1,100, and the yield falls to $4.5%.

What should investors do?
A: If you're sincerely worried about deflation, then it makes sense to own some Treasury securities. But, warns Pimco Bond guru Bill Gross, you won't get much. A two-year T-note now ...