So inflation by far is a bond investor's biggest enemy. Conversely, inflation is a bond issuer's best friend. Unfortunately, bond investors run into problems when the largest debt issuer and the one who prints money are the same entity.

The German hyper-inflation

Most people are familiar with Germany's hyperinflation which occurred after World War I. This inflation was instigated by the German government which had war debts to repay. In the hyperinflation of 1923, prices rose by about 10 billion times.

The benefits gained by debtors are easy to see in Germany's hyperinflation. If you're the German government and are heavily indebted, the interest payments alone will swallow all your tax revenues.

Inflation, however, provides an easy way out for you. If this year one mark buys a loaf of bread, but next year it takes ten billion marks to buy that same loaf of bread, a multi-trillion mark debt soon becomes more "manageable" -- even insignificant.

The German hyperinflation was only eliminated when Germany issued a new currency that was backed by gold and with the creation of a new, independent central bank that wasn't a puppet of the government.

The problems with inflation

There are of course, two big problems with governments that think that inflation will bail them out of their problems. First, lenders simply stop loaning money on a long-term basis. No lending means no investment and poor prospects for the economy.

The other problem with inflation is it hurts the weakest people in society. Suppose you're a retired German worker in the early 1920s. You've saved maybe a hundred thousand marks, and between interest and tapping your principal you're able to survive.

Unfortunately, inflation hits and your entire retirement stash of a hundred thousand marks, which took you a lifetime to accumulate, now won't even buy you a cup of coffee!

Things aren't as bad for workers, because their wages are being inflated, but if you can't work, you become completely dependent on the crumbs the government or other organizations might throw your way. As you can see, inflation has severe consequences for bond investors and retirees.

The US and the gold standard

For a long time the ability of the US federal government to generate paper dollars was limited because these dollars had to be backed by gold reserves. While the US was on the classical gold standard from 1880 to 1914 inflation in the US averaged 0.1 percent annually.

But the US began to back away from the gold standard in the 1960s as President Johnson decided to undertake the expensive Vietnam War and the War on Poverty. The United States began to print more dollars than it had gold reserves to back up.

Throughout the late 1960s everyone knew that inflationary pressures were building in the United States. The government maintained that the dollar was as good as gold, while at the same time was flooding the world market with dollars that really weren't backed by gold.

The whole thing fell apart in 1968 when the US government refused to ship gold to so-called speculators at the official rate of $35 to the ounce. Meanwhile, real gold was trading in real markets for $43 an ounce. President Nixon officially rebuked any pretext of a gold standard in 1971 when he said that the dollar would no longer be convertible into gold at any price.

The effects were immediate and obvious. On world-wide currency markets the dollar quickly lost 20 percent of its value, and Nixon had to impose wage and price controls in a vain attempt to stop inflation.

Sell bonds during a war

The inflation that accompanied the Vietnam War is proof that bonds are poor investments during a war.

For some reason, when war breaks out people panic and trade their stocks for bonds. Apparently they think that bonds are safer than stocks. Stocks are generally less volatile than bonds, but buying bonds during a war almost always is a losing bet.

Wars bring inflation, and stocks are the financial assets which are more likely to weather the ensuing inflation. And if you're in an area where the war is hot, think about buying hard assets like jewels which can be smuggled easily out of the country.

The inflationary effects of war can be seen in America. America suffered serious bouts of inflation in 1920, the mid-1940s and the 1970s. These inflationary times occurred after major wars. In fact, the US recorded its highest level of inflation in 1946 when inflation reached 18 percent.

Only strict rationing and price controls prevented inflation from reaching higher levels during World War II. In fact, the rent controls which eventually destroyed large sections of cities like New York got their start as World War II price controls. If you want to buy war bonds, fine, but you'd better write off a good chunk of your investment as a patriotic sacrifice because the war's inflation will eat away at the value of the bond.

Bracket creep - inflation helps the government

As the biggest debtor, the US government doesn't mind seeing inflation reduce the value of the debt it owes. But the federal government also gains more tax revenues through higher inflation. This became especially obvious in the late 1970s.

The US federal government has a multi-bracket tax system whereby the so-called rich pay a higher percentage of their income in taxes. Currently, low-income workers face marginal rates of zero to 15 percent, while the highest income workers give about 40 percent of their last dollars to the federal government.

I cover other tax topics in my tape on income tax planning, but let's see how inflation can increase your tax burden.

Assume you're working in an environment where inflation is 20 percent. Last year you made $50,000 and were in the so-called "middle income" tax bracket of 28 percent.

This year you got a 20 percent raise to keep you even with inflation, so you're now making $60,000. In real terms, you're still making the same amount of money as you did last year.

However, according to the government, your $60,000 income now marks you as being one of "the rich", and since you're rich, you should pay more in taxes. So this year the government places you in the 31 percent marginal bracket, higher than the 28 percent bracket you were in last year.

This example is extreme because 20 percent inflation is high, but you get the same effect over three or so years of moderate inflation. However, inflation was so bad in the late 1970s that this bracket creep was hurting a lot of people.

To help remedy this, major sections of the tax code were indexed for inflation in the early 1980s. However, there are still many cases where the government is able to collect higher taxes through inflation, so the government still views inflation as its friend.

A good example is capital gains. Let's say you invest $10,000 in stocks. Over the next 10 years prices double due to inflation. Over 10 years your stocks also doubled in price, and you sell them for $20,000.

In real terms, you didn't make any money on your stock investment after inflation. But according to the government, you have a $10,000 taxable capital gain.

So the government likes inflation because it effectively reduces its debt burden while increasing tax receipts. But investors have come to understand this after being burned badly in the 1970s. Now investors are demanding a higher inflation premium before they'll lend to the government or anyone else.

Real long-term returns on bonds

For most of the past 70 years, long-term government bonds have yielded about 2 percent more than inflation. Now, investors are demanding almost 4 percent more than inflation.

The bond market also reacts quickly to news about potential inflation. At one time it was safe for widows and orphans to invest in long-term bonds because interest rates were stable and inflation was moderate.

Bond market is very volatile now

Now however, the bond market is volatile. If the economy begins to grow at a high rate, this may translate into inflation which will destroy bond values. So if news comes out about excessive job growth, bond traders take this as good news for the economy but bad news for the bond market.

In fact the bond market perversely loves bad economic news. If the economy is weak, inflation will be low, and bond prices will increase. In fact, the Great Depression of the 1930s was a terrible time for stocks, but a fantastic time for bonds.

In the early 1930s bond prices doubled while stock prices fell by almost 90 percent.

So the bond market reacts violently to news about the economy and the government's willingness to control inflation. It's not uncommon to see long-term bond prices move by 2 or even 3 percent in one day.

Bond volatility vs. stock volatility

This kind of move rarely makes headlines, but I can guarantee that if the stock market lost 3 percent of its value in one day, there would be headlines about it. Because the bond market has become nearly as volatile as the stock market, returns from the bond market may be close to returns from the stock market for the foreseeable future.

This is because investors want the maximum return for the lowest risk. If bonds have become riskier, and they have, the returns from bonds also should increase.

So although nowadays everyone seems to be saying that stocks are the only place to be, bonds might be a good place to be for the last half of the 1990s. But keep your eyes out for inflation and the government's level of debt.