Want some really bad news? If your income-stream is taxed at ordinary-income rates (currently, 25%), and if your personally experienced inflation rate is running at 5%, then the CY on your bond or pfd has to be 6.67%, or else you not even breaking even. So let work an example.
Buy a pfd at $25 par with a 7% coupon that matures in 8 years. You’re going to gross $14 bucks in divs, right? but only net 75% of that due to taxes, or $10.50. At maturity, you get back your $25 principal, now worth just $16.92 due to inflation. But your divs also have to be discounted for inflation. So your net from divs is just $8.64. Add those two together, and the net-gain on your investment is an underwhelming $0.56 cents, or roughly $0.07 cents per year for 8 years of risk, worry, and grief.
Here are my assumptions. From 30 years of tracking my expenses, I know that my personally experienced inflation rate averages around 4.5%/yr. For ongoing budgeting purposes, I round that up to 5%. For longer-range, retirement planning purposes, I’ve always notched that one number higher to 6%. Currently, the CPI is printing at 8.6%. But if the same metrics are used as were used in the 1980 version of the CPI, then inflation is running closer to 22% (or whatever number John Williams is now reporting).
In the old days, the CPI was a useful index. Though each house didn’t buy every item in the index in the same amounts as the index, the differences tended to averages themselves out. Not so these days, because the BLS --aka, the Bureau of Economic Propaganda-- has tweaked the index into near uselessness, and it uses the index to understate inflation, just as they use the GDP to overstate domestic productivity. But if “officially reported” inflation is running 8.6%, and one’s own shopping experiences at the grocery and gas pump don’t contradict that, then one’s personally experienced inflation number has to be bumped higher. So, let’s guess 6% might be one’s average over the next 5 years.
There’s a move afoot in Congress and the White House to raise taxes. My bet is they won’t be able to make it happen unless they really do want a real “insurrection”. So let’s assume that the 25% tax-rate on ordinary income stays in place.
Calculating the exact impact of inflation on the purchasing-power of one’s dollars can be done in a spreadsheet by writing formulas and populating columns. But a good enough approximation can be done with math. If the value of $1 dollar in year one is $1, then its value in year two is $0.94 cents if inflation is running at 6%. The third year, the value becomes 94% of the previous year’s value, or $0.8836. So what you have is compounding function, where the inflation for any given year is the reciprocal of the power of the inflation rate, thusly, 1/((1+I)^P), I = whatever inflation rate you want to use expressed as a decimal and P = whatever length of time you want to use, again expressed as decimal
Yeah, that bunch of symbols looks nasty. But the process is of entering them on a scientific calculator is easy.
Step One. Guess a rate a inflation expressed as a decimal. [Thus, 6%, = .06]
Step Two. Add the number ‘1’. to that. [The display should now read ‘1.06’]
Step Three. Find the key that says something like X^Y.
To test that you’ve found the right key, clear the display and enter the number ‘2’. Hit the X^Y key and enter the number ‘3’. The result should be '8", because 2^3 = 8. (I.e., 2 x 2 x 2 = 8.)
Go back to Step One. Guess an inflation rate. Add the number ‘1’. Hit the X^Y key. Enter the number of years you want inflation to run. If you used 6% inflation and five years, the display should read 1.338225578.
Last Step. Find and hit the reciprocal key that looks like this, 1/X. The display should now read 0.747258172. Move the decimal two places to the right and chop the tail.
Answer. If inflation is running at 6%, in five years the purchasing-power of your dollar has become $0.75 cents. If inflation really is running at 8.6%, then by the next presidential election, 2-1/2 years away, your dollar will only be worth $0.81 cents. And if you really want to drive yourself crazy, do a paper trade on a perpetual pfd and run the numbers to see just how much money you won’t be making unless you’re buying some really toxic, high-div trash, and then your fears shouldn’t be inflation, but the issuer defaulting.
Yeah, this post is tedious long, and the points I’m making are tediously obvious, for this reason. If I can explain this stuff to someone else, I can explain it to me. I’m worried about what lies ahead of us financially and just trying to see what can be done to limit the likely damage.
PS To estimate the impact of inflation on a multi-year income stream, discount the divs for the impact of taxes and then divide the holding period in half. That number becomes the power by which your estimated inflation rate will be raised. Not exact. “But good enough for the girls I go dancing with”, as my foreman used to say when I was booming out, overhauling turbines, and life was far simpler.