How inflation protected bonds work How inflation protected bonds work How inflation protected bonds work

How inflation protected bonds work

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What are inflation protected bonds? 

An inflation protected bond is an instrument that enables risk-averse investors to shield their portfolio from the negative impacts of inflation. These bonds are usually acquired directly through national government agencies, with guaranteed interest payments linked to the country’s rate of inflation. At the maturity of the bond, the overall return is inflation-adjusted or the original sum invested, whichever sum is higher. 

If you’re wondering whether inflation protected bonds could be a savvy move to shield your overall investment portfolio from sizeable losses in the event of surging inflation and interest rates, read on as we explain how they work, their pros and cons and the alternative ways to invest in them. 

How does inflation influence an investment portfolio? 

At a time of rampant inflation, volatility is rife in the financial markets. With uncertainty surrounding interest rates, equities are often at risk, particularly growth stocks like big tech, which are heavily impacted by higher costs for borrowing. 

Fixed-income investments aren’t immune from the negative effects of inflation either. For example, bonds that have a fixed return of 5% against a backdrop of 10% inflation are actually providing a negative yield of -5%. The priority for developing a futureproof investment portfolio is to ensure it yields a greater return than inflation, ensuring a positive real-money return. 

How do inflation protected bonds work? 

Inflation linked bonds are debt instruments issued by governments, with the funds used to finance new infrastructure projects or ongoing tasks. 

Bonds usually pay interest against the bond’s principal value. Once the bond reaches maturity, the principal value is realised by the investor. Inflation protected bonds are unique in that their interest payments rise and fall in line with a country’s official rate of inflation. 

In the US, inflation protected bonds are aligned with the value of the U.S. Consumer Price Index (CPI) and these bonds are sold directly by the US Treasury. In the UK, inflation protected gilts are sold by the UK’s Debt Management Office and are tied to the UK’s Retail Price Index (RPI). 

It’s possible to find additional inflation linked bonds issued by major corporations instead of national governments, but these types of instruments are most commonly available via governments. 

What are the benefits of inflation linked bonds? 

One of the biggest upsides to investing in inflation linked bonds is that it’s a convenient hedge against potential risks in other securities. They reduce potential uncertainty within your portfolio. If your equities are losing value during cost-of-living crises and recessions, inflation protected bonds can offer a guaranteed income that breaks even at the very least in real terms. 

Another benefit of an inflation protected bond is that providing inflation meets the market expectations, your returns will be positive. If inflation exceeds market expectations and is even more rampant than expected, inflation protected bonds can prove an even savvier move. Typically, if prices and yields are in line with inflationary expectations, returns from inflation linked bonds are often no better or worse than other fixed-income investment options. However, if inflation is that much greater, they can outperform other fixed-income securities. 

Looking at a long-term average, the performance of inflation protected bonds has typically outperformed other fixed-income bonds. Inflation linked bonds have provided an average annual return of 6%, compared with the average annual return of 4.5% with fixed-income bonds. However, it’s important to be mindful that this is still significantly down on the 9% average annual return from the stock markets. 

What are the drawbacks of inflation linked bonds? 

The ceiling on your potential profits 

The main drawback of investing in inflation protected bonds is the limited growth potential. The return potential is essentially based on the rate of inflation at the time of the bond’s maturity. As it doesn’t have the ability to yield outlandish gains – or losses – you should look to use these bonds sensibly as a ballast for your broader portfolio. 

Interest rates can hurt a bond's value 

The value of these bonds is also at the mercy of rising and falling interest rates, as well as inflation rates. In fact, US-based Treasury Inflation Protected Securities (TIPS) offer limited protection in times of economic deflation. The US Treasury defines a par value for any TIPS, but older TIPS that have accrued inflation-adjusted returns in times of high inflation can see it lost to deflation just as quickly. 

Most retail investors will look to gain access to inflation protected bonds as index funds and ETFs. The issue with this is that most funds will have lengthy durations attached to them. 

Duration denotes how sensitive a fund is to fluctuations in interest rates. The greater the figure, the more the fund is likely to plunge when rates increase and vice versa. These high-duration funds are packed with inflation protected bonds with lengthy periods of maturity, sometimes upwards of 25-30 years. 

High-duration funds are at risk of volatile periods for interest rates and inflation. When interest rates are hiked, it could lead to a sizeable drop in the bond fund’s overall value. 

CPI and RPI is not always the best barometer for inflation 

It's also up for debate whether the measure of inflation used to determine CPI and RPI in the US and UK is relevant. This index is based on a ‘basket’ of services and goods that typical households will spend their money on each month. 

If you’re investing in bonds to shield you from inflation, these measures must be accurate, otherwise, it’s not protecting you. In the UK, the Office of National Statistics (ONS) recently said that RPI was a “very poor measure of general inflation” and was guilty of “greatly overestimating” and “underestimating” inflationary shifts through the years. 

Relying on any single measure of inflation is always going to be risky. Given that every household spends its disposable income differently, our inflation rates are much more personal than you would otherwise think. 

Less effective for those newly building investment portfolios 

Another reason inflation protected bonds may not be best suited to your investment portfolio is if you’re not endangered by short-term inflation. If you’re just starting in your investment journey for the decades ahead, the chances are your disposable income will be generated through your employment income, rather than your portfolio. 

If you’re still accumulating assets within your portfolio for the future, the role of these bonds is going to be less crucial. 

It’s those relying on their portfolio to fund their lifestyle, usually in retirement, that may be better off investing in these types of bonds to reduce portfolio risk and mitigate the dangers of stock market crashes. 

How to purchase inflation protected bonds 

Buy inflation-linked bonds via a broker 

It’s possible to buy these types of bonds directly via a broker. These can be accessed via what’s known as a ‘first-issue’ i.e. the entity issuing the original bonds, or the ‘secondary market’ i.e. via investors that had previously gained them from the issuing entity. 

For example, it’s possible to invest in inflation-linked bonds directly via the American government. Bonds can be purchased in increments of $100, making it a credible option for even entry-level long-term investors. These are described by the US government as ‘Treasury Inflation Protected Securities’ (TIPS) and can be issued for five, seven or 30-year terms. Bonds must be held for at least 45 days and are only available in digital form. 

Other such schemes exist in other nations, too. The Italian government offers bonds known as BTPs, which are government securities linked to the country’s rate of inflation. 

Invest into mutual funds with exposure to inflation-protected bonds

If you don’t have the time or the inclination to hand-pick inflation protected bonds off your own back, you may want to look at investing in mutual funds. Certain funds have significant exposure to inflation-indexed bonds, with some dealing only in US-based TIPS if you’re most interested in the US economy. The VIPSX from Vanguard and the FIPDX from Fidelity are two prime examples. 

It's important to make a note that interest paid on inflation-linked bond funds is deemed taxable income. Taxable income can even be generated just by investing in the mutual fund and not liquidating any of your shares in the fund. It’s for this reason that some investors use mutual funds with inflation-linked bond exposure for their retirement funds, as returns will stay in line with future rates of inflation and won’t be devalued. 

Invest in bond ETFs 

Instead of investing in inflation-indexed bonds in a tax-deferred account, there’s always the option to buy bond exchange-traded funds (ETFs). Investing this way gives you greater control over how you accrue taxes. You’ll pay an ETF manager to oversee the basket of securities included within the ETF and you’ll invest funds into it to get direct exposure to said securities. 

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