Understanding Inflation-Indexed Bonds

Understanding Inflation Indexed Bonds
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Inflation always impacts the performance of your investments. Skyrocketing inflation is giving Americans an object lesson on this fact of investing life, with the most recent consumer price index (CPI) reading up 8.3% on an annual basis.

For investors, “real returns” are how much you earn from an investment after taking inflation into account. If your portfolio returned 9% over the last year, your real rate of return would be just 0.7%, given the current CPI.

Inflation-indexed bonds—also called inflation-linked bonds—offer one way to mitigate rising prices, since the returns of these fixed-income securities are adjusted to account for inflation.

What Are Inflation-Indexed Bonds?

With conventional bonds, investors get a fixed interest rate and receive regular interest payments, also known as coupon payments. The latter are in nominal dollars, meaning an amount that is not adjusted for inflation. The bond’s principal is returned once it reaches maturity.

The inflation risk for conventional bonds is significant, since rising inflation can erode the bond’s value over time.

Let’s say in January you purchase $10,000 in one-year bonds. They pay a 5% annual interest rate, and you get back your principal at maturity. At the end of the year, you will get $10,500, but the real value of that return depends on annual inflation.

If inflation was 5%, then you can expect a return of zero on your bond investment. Thanks to rising prices, that $10,500 simply preserved the same purchasing power you had with $10,000 at the start of the year.

Inflation-indexed bonds pay a fixed interest rate, offer regular coupon payments and return the principal at maturity. Here’s where they’re different: The principal is regularly adjusted for inflation, and the fixed-interest rate is applied to the adjusted principal.

How Do Inflation-Indexed Bonds Work?

Inflation-indexed bonds reference a market index that measures inflation, like CPI. As the index rises and falls with inflation, the value of the bond’s principal is adjusted, changing the amount you earn with each coupon payment.

Let’s return to our one-year bond example. If you purchased $10,000 in inflation-indexed bonds in January that promised a 2% real return, and the inflation rate reaches 5% for the year, the principal of the bond would be increased to $10,500.

At maturity, the bond would pay you interest equal to 2% of $10,500—or $210, in this case. Thanks to the inflation adjustment, you would preserve the purchasing power of your money and also earn a 2% return.

Pros of Inflation-Indexed Bonds

  • Fixed long-term yield. Inflation-indexed bonds offer a fixed, long-term yield. This is appealing to investors who want the stability of a fixed-income investment but are worried about the impact of inflation.
  • Zero inflation risk. They have no inflation risk, meaning your investment is protected against rising prices. This is in contrast to conventional bonds, which can lose value in real terms if inflation rates rise.
  • Returns are not linked to the market. The return on inflation-indexed bonds has no correlation to the returns of the stock market, so they can provide a hedge against inflation and provide valuable diversification.

Cons of Inflation-Indexed Bonds

  • Less earning potential than other securities. Inflation-indexed bonds have less earning potential than other securities, such as stocks. That’s because they offer a fixed return, while other securities offer the potential for higher returns. In addition, if inflation rates are low, you may not earn as much on your investment as you would on a different security.
  • Not a perfect measure of inflation. CPI is the most common measure of inflation for U.S. inflation-indexed bonds. However, it’s hardly a perfect metric. Some experts warn there’s some uncertainty regarding how well inflation-indexed bonds will protect your investment from price rises.
  • Phantom income. In the U.S., phantom income is defined as unrealized gains on investments that are not subject to current taxes. In other words, it’s money you have earned but haven’t actually received yet. With inflation-indexed bonds, phantom income can occur when the CPI rises and the value of your bond increases.

How to Invest in Inflation-Indexed Bonds

Two of the most common ways to purchase inflation-indexed bonds are through Treasury Inflation-Protected Securities (TIPS) and funds.

Treasury Inflation-Protected Securities

TIPS are the best-known inflation-indexed bonds in the U.S. Unlike other securities sold by the U.S. Treasury, the principal value of TIPS can change over its term, adjusted based on CPI.

When the TIPS matures and the principal is higher than the original amount, you get a higher amount. If the TIPS is equal to or lower than the initial amount, you will get the original amount.

TIPS pay a fixed rate of interest every six months until they mature, and terms range from five to 30 years. You can purchase TIPS directly from the U.S. Treasury at TreasuryDirect.

Index Funds and ETFs

To invest in inflation-indexed bonds without purchasing individual securities, you can invest in an index fund or an exchange-traded fund (ETF).

Inflation-indexed funds are index funds or ETFs that track a specific index, such as the Bloomberg World Government Inflation-Linked Bond Index.

Read More: The Best ETFs to Beat Inflation

Index funds offer the benefit of diversification and professional management, allowing you to invest in hundreds of bonds with each share you purchase.

Should You Invest In Inflation-Indexed Bonds?

Inflation-indexed bonds offer stability and protection against inflation for investors. However, there are some drawbacks to investing in these securities, such as less earning potential than other options and uncertainty around the accuracy of the inflation rate measure used.

Inflation-indexed bonds may have a place in your portfolio, but it’s a good idea to meet with a financial advisor to discuss your goals and investment strategy to make sure you’re on the right track.

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