About Inflation: What Are Inflation Bonds?

Inflation-linked bonds are bonds whose principal value changes with fluctuations in the inflation index.

Inflation
Bonds
Portfolio
About Inflation: What Are Inflation Bonds?

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Building the right tech stack is key

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How to choose the right tech stack for your company?

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What to consider when choosing the right tech stack?

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What are the most relevant factors to consider?

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What tech stack do we use at Techly X?

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Inflation-linked bonds, also called inflation-indexed bonds, are types of bond investments whose principal value changes with a change in an index measuring the rate of inflation. Because of their ability to adjust with rising inflation, these investments offer investors more risk protection in market environments driven by rising inflation. 

Before we learn how inflation-linked bonds work, let’s dive deeper into what inflation is, how it’s measured, and how it impacts investors.

What is Inflation?

Inflation refers to the general increase in prices of goods in a specific country or economy over a given period. Naturally, as prices increase, a specific amount of money can buy fewer things – the purchasing power of money decreases with a rise in inflation. 

This decrease in purchasing power can have a direct negative impact on the return of your fixed income investments such as bonds.

How is Inflation Measured?

Inflation is measured using an index computed by the U.S. Bureau of Labour Statistics. This index, called the consumer price index (CPI), records the price changes of a basket of consumer goods over a time period. Each month, the CPI records the prices of 80,000 consumer goods and then publishes the change in these. This rate of change is called the inflation rate.

Core Inflation vs. Headline Inflation

Core inflation measures the inflation according to the CPI but excludes the changes in prices of commodities that are more volatile (e.g., energy and food). The core inflation rate is used by central banks and the federal government to track inflation and adjust interest rates to curb it.

Headline inflation is rarely used in developed economies because it includes the prices of volatile commodities. Due to this volatility, it is also less reflective of the real-world inflation and doesn’t provide appropriate forecasting data.

Why Inflation Matters?

One of the most significant ways inflation affects an economy is the rise in interest rates by the central bank. Most central banks have a mandate to keep inflation low and stable at around 2%. If inflation rises beyond this rate, central banks are forced to raise interest rates.  

In the U.S., the Federal Reserve sets interest rates. Typically, the interest rate and the inflation rate are directly correlated, i.e., when inflation rises, so do interest rates and vice versa. The Fed targets a year-on-year inflation rate of about 2%, and to curb the effects of inflation, it raises interest rates.

These increased rates discourage spending for both consumers and businesses, limiting overall demand for various goods. It also makes the cost of borrowing more expensive. Additionally, rising borrowing rates also increase the amount of risk-free reserves and discourage spending/investments in riskier assets like real estate. 

To consumers, the decrease in the purchasing power of money can reduce the consumption of goods and services. Rising inflation also increases the cost of living because of higher mortgage rates. 

For businesses, too, rising inflation increases the cost of production, which negatively impacts profit margins. Moreover, inflation also increases the cost of borrowing money (interest rates), which makes it difficult for businesses to secure funding. Other possible effects of rising inflation include supply chain disruptions and decreased demands for some goods. 

How Inflation Affects Bonds

While inflation affects the average returns of almost every asset class, we will focus on bonds in this post. Nominal bonds include a fixed interest rate and regular interest payments for investors. In a market environment where inflation is stable and economic growth comes in below expectations, nominal bonds provide stable returns for investors. But when inflation rises, nominal bonds are not a good investment. 

To understand the effects of inflation on nominal bonds, imagine a scenario. Suppose you invested $5,000 in one-year nominal corporate bonds with a 5% interest rate. Throughout the 12 months, you will get your fixed interest payment of 5% on the $5,000 and at the end of the period, you will receive your principal. During this period, consider the inflation to be around 5%, too. What happens to your returns then? 

Considering that your overall gain on this investment was only about 5%, the rise in inflation at the same rate means the purchasing power of your principal will be the same as the initial amount you invested. Even though in theory you do receive an amount of $5,250, its value is the same as $5,000, giving you a net zero real return on your investment. Had the inflation rate been even higher than the coupon rate, your net after-inflation (or real) return would be negative. 

This is why instead of allocating all your capital towards nominal bonds, you should consider investing some in inflation-linked bonds.

What Are Inflation Linked Bonds?

Graph showing how inflation affects bonds
Source: https://global.pimco.com/en-gbl/resources/education/understanding-inflation-linked-bonds

As mentioned earlier, for inflation-linked bonds, the principal is indexed to the rate of inflation. They are a type of sovereign government bond. When inflation rates rise, the principal amount also changes to reflect this rise. Inflation-indexed bonds still pay a fixed rate of coupon. However, since this rate is applied to the adjusted principal, the actual amount of interest payments also changes with changes in inflation.  

Inflation-linked bonds are typically indexed to inflation indicators like the consumer price index (CPI) in the U.S., the retail price index (RPI) in the U.K., and European harmonized index of consumer prices (HICP) in Europe. Developing countries also issue inflation-linked bonds indexed to their standard inflation indices. 

If you invest $5,000 in inflation-indexed bonds with a real return of 2%, here’s what will happen to your returns: suppose the inflation rate is 5% again, the adjusted principal a year later would be $5,250, and you would be paid 2% interest on this adjusted principal. This would make your nominal return $5,355. This way, not only does the purchasing power of your investment remain intact, but you also earn a 2% real return (after adjusting for inflation eroding purchasing power).

Real Yield Vs. Nominal Yield

In the case of inflation-linked bonds, the return an investor gets is called real yield. Real yield of such bonds is the annual coupon rate minus the rate of inflation over a specific time period. This rate of return is specified over and above the inflation rate.

In the case of nominal bonds, the coupon rate is fixed and paid over a future time period. Since it’s not possible to accurately predict inflation for the future, the coupon payments remain constant without accounting for inflation. 

Types of Inflation-Indexed Bonds

I-Bonds

I-bonds are inflation-indexed savings bonds issued by the U.S. government. These bonds offer both a fixed interest rate and a rate that adjusts for inflation. Every 6 months, the inflation-influenced rate is changed. Additionally, the interest on an I-Bond is paid monthly and compounded every six months.

Treasury Inflation-Protected Securities

TIPS are securities sold by the U.S. Treasury.  The principal value of TIPS depends on the CPI and changes according to the index.

If the TIPS maturity principal is higher than the principal invested in the beginning, your returns are higher. If it is equal to or lower than the initial amount, you receive the original principal amount as return.

TIPS pay a fixed interest rate every six months. You can purchase TIPS directly from the U.S. Treasury at TreasuryDirect.

Index Funds and ETFs

Instead of purchasing individual securities, you can invest in an index fund or an exchange-traded fund (ETF) to have inflation-indexed bonds in your portfolio. Inflation-indexed funds track an index such as the Bloomberg World Government Inflation-Linked Bond Index.

Advantages of Inflation-Indexed Bonds

1. Fixed Long-Term Yield 

Inflation-indexed bonds offer a fixed, long-term yield. If you’re looking for stable income from your fixed-income investments without worrying about inflation, inflation-linked bonds are a great choice.

2. Uncorrelated Returns

The return on inflation-indexed bonds has a low correlation to the returns of the stock market, providing valuable diversification.

3. Inflation Hedge

Inflation-linked bonds are one of the few asset classes that do not carry inflation risk because they adjust with changes in inflation. 

Disadvantages of Inflation-Indexed Bonds

Lower-Than-Expected Returns When Inflation is Low

When inflation comes in below expectations, the returns of inflation-linked bonds are worse than returns of nominal bonds because inflation-linked bonds pay out in terms of the actual inflation. 

Wrapping Up

Inflation-linked bonds are a great fixed income investment in market environments where inflation comes in above expectations because they offer inflation protection. But basing your investment decisions on predictions of the market environment can cause your returns to be excellent at some times and poor at others. The best way to invest in inflation-indexed bonds is to balance them with other assets and construct a diversified portfolio. 

A Hedgeful investment portfolio contains the right proportion of nine major asset classes, including inflation-indexed bonds. Such a diversified, balanced portfolio is equipped to protect investors from sudden market fluctuations or changes in inflation/growth above or below expectations. 

Inflation
Inflation
Bonds
Bonds
Portfolio
Portfolio