How inflation-linked bonds work

Key takeaways:

• Inflation-linked bonds are designed to help protect purchasing power against a referenced inflation index, but they do not remove investment risk.
• Inflation can reduce real returns across portfolios, especially when bond yields or investment returns fail to keep pace with rising prices.
• How inflation-linked bonds work depends on the bond terms, but many adjust principal using an inflation index, with coupons calculated on the adjusted amount.
• Benefits may include inflation-risk management, but drawbacks include limited growth potential, interest-rate sensitivity, index mismatch and possible negative real returns.
• Investors can purchase inflation-linked bonds directly, through brokers, mutual funds or ETFs, while reviewing costs, duration, tax treatment and product structure.

What are inflation-linked bonds?

An inflation-linked bond, sometimes called inflation-protected bond, is a debt instrument designed to help protect purchasing power against a referenced inflation index, but it does not eliminate investment risk. These bonds may be purchased directly from a government in some markets, or through brokers, funds or ETFs, depending on the country and product. Their structure varies, but many government inflation-linked bonds adjust principal using an inflation index, with coupon payments calculated on the adjusted principal. At maturity, some inflation-linked government bonds, such as US TIPS (Treasury Inflation-Protected Securities), repay the inflation-adjusted principal or the original principal, whichever is higher; features can differ in other countries.

If you’re considering whether inflation-linked bonds could play a role in managing inflation risk within your portfolio, this guide explains how they work, their pros and cons and alternative ways to access them.

How does inflation influence an investment portfolio?

During periods of elevated inflation, financial market volatility can increase. With uncertainty surrounding interest rates, equities can come under pressure, particularly growth stocks, which may be sensitive to higher borrowing costs and changes in discount rates.

Fixed-income investments aren’t immune from the negative effects of inflation either. For example, a bond paying 5% when inflation is 10% implies a negative real return of around 5%, before tax and other costs. One aim for investors concerned about inflation is to seek returns that outpace inflation over time, but this is not guaranteed.

How do inflation-linked bonds work?

Inflation-linked bonds are debt instruments often issued by governments; like other government bonds, proceeds form part of public financing.

Bonds usually pay interest based on the bond’s principal value. Once the bond reaches maturity, the issuer repays the principal according to the bond’s terms. Inflation-linked government bonds typically adjust the principal using an inflation index; because coupons are calculated on the adjusted principal, cash interest payments can rise or fall over time.

As previously mentioned, in the US, these securities are known as Treasury Inflation-Protected Securities, or TIPS. They are linked to the Consumer Price Index, and investors can access them directly through the US Treasury or through banks, brokers, funds and ETFs. In the UK, similar securities are known as index-linked gilts and are linked to the Retail Prices Index, with the exact mechanics depending on the gilt’s terms.

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 potential benefit of inflation-linked bonds is that they may help manage inflation risk within a broader portfolio. They may reduce one source of uncertainty within a portfolio, although they introduce other risks, including interest-rate risk and market-price risk. If your equities are losing value during periods of inflation or recession, inflation-linked bonds may help protect your purchasing power relative to the referenced inflation index, but real returns can still be negative depending on real yield, taxes, fees and market pricing.

In general, returns depend on the bond’s real yield at purchase, how inflation develops relative to market expectations, and whether the bond is held directly or through a fund. Positive returns are not guaranteed. If inflation exceeds market expectations, inflation-linked bonds may perform differently from conventional bonds, but outcomes still depend on starting valuation, duration, taxes and fees. If inflation is broadly in line with what markets have priced in, inflation-linked bonds may not outperform conventional fixed-income options. However, if realised inflation is higher than expected, they may outperform some conventional fixed-income securities, depending on pricing and duration.

Over some periods, inflation-linked bonds have outperformed conventional bonds, while in other periods they have lagged.