Mitigating Inflation with Inflation-Indexed Bonds

Mitigating Inflation with Inflation-Indexed Bonds

Inflation can erode the real returns of fixed-income investments by decreasing their purchasing power over time. Even when inflation is moderate, it can still impact returns. For example, if your portfolio returns 9% and inflation is at 3%, your real return is just 6%.

Inflation-linked bonds, which adjust for inflation, are a useful hedge against inflation risk. These bonds, issued by countries like the U.S., India, and Canada, are particularly beneficial for long-term investors seeking to reduce uncertainty.

Key Points:

• Inflation-linked bonds adjust in value during periods of inflation, making them a hedge against rising prices.
• Countries such as the U.S., U.K., Canada, and India issue inflation-indexed bonds.
• These bonds may not offer strong protection during deflationary periods.
• A key advantage of inflation-linked bonds is that their returns do not correlate with stock or other fixed-income asset performance.

How Inflation-Linked Bonds Operate

Inflation-linked bonds are pegged to inflation indices, such as the Consumer Price Index (CPI), reflecting changes in the cost of goods. Different countries use their own measures to track inflation and issue bonds accordingly. For instance:

• The U.S. Treasury offers Treasury Inflation-Protected Securities (TIPS) and inflation-indexed savings bonds linked to the U.S. CPI.
• The U.K. issues inflation-linked gilts, connected to the country’s Retail Price Index (RPI).
• Canada’s real return bonds are issued by the Bank of Canada, and India’s inflation-indexed bonds are offered through the Reserve Bank of India.

The principal value of inflation-linked bonds generally rises when inflation increases. In contrast, many other asset classes decline in value during inflationary periods. Furthermore, the interest payments from inflation-linked bonds adjust according to inflation, providing added protection against the real impact of inflation.

Historical Context

Inflation-indexed bonds originated during the American Revolution to address inflation’s impact on purchasing power. While Massachusetts issued these bonds in 1780, inflation-indexing became unnecessary under the gold standard. However, the demand for inflation-protection re-emerged in the 1970s after the gold standard was abandoned. In 1981, the U.K. issued the first modern inflation-linked bonds. Other countries, including the U.S. and India, followed in the 1990s.

Risks of Inflation-Linked Bonds

While inflation-linked bonds offer valuable protection, they carry certain risks:

• Interest rate fluctuations can affect bond values.
• Inflation-linked bonds do not perform well during deflation, with TIPS being an example where older issues with inflation-adjusted accruals may lose value in deflationary environments.

Trading and Taxation Complexities

Inflation-linked bonds present unique challenges in trading and taxation due to the distinction between their original face value and the inflation-adjusted value. For tax purposes, annual inflation adjustments are considered income, even though they aren’t received until the bond matures, leading to what’s known as “phantom income.”

What Are Inflation-Linked Bonds?

Inflation-linked bonds are government-issued, fixed-income securities designed to shield investors from inflation. Both the principal and interest rise or fall based on inflation metrics, such as the CPI.

Assessing the Risk of Inflation-Linked Bonds

Although these bonds offer inflation protection, they are still subject to interest rate risk and deflation risk, particularly in countries like the U.S., where inflation-linked bonds are tied to CPI measurements.

Current Inflation Bond Rates

As of the second half of 2023, the rate for U.S. I bonds is 4.30%, which includes a 0.90% fixed rate.

Bottom Line

Inflation-indexed bonds remain a popular option for protecting portfolios against inflation’s damaging effects. Despite their complexities and some downsides during deflationary times, these bonds provide a crucial hedge against inflation while also offering portfolio diversification.