Hedge Your Bets With Inflation-Indexed Bonds

Inflation can have a dampening effect on fixed-income investments by reducing their purchasing power and cutting their real returns over time. This happens even if the inflation rate is relatively low. If you have a portfolio that returns 9% and the inflation rate is 3%, then your real returns are about 6%.

Inflation-index-linked bonds can help to hedge against inflation risk because they increase in value during inflationary periods. The United States, India, Canada, and a wide range of other countries issue inflation-linked bonds. Because they reduce uncertainty, inflation-indexed bonds are a popular long-range planning investment vehicle for individuals and institutions alike.

How Inflation-Linked Bonds Work

Inflation-linked bonds are tied to the costs of consumer goods as measured by an inflation index, such as the consumer price index (CPI). Each country has its own method of calculating those costs on a regular basis. In addition, each nation has its own agency responsible for issuing inflation-linked bonds. For instance:

• In the United States, Treasury Inflation-Protected Securities (TIPS) and inflation-indexed savings bonds (I bonds) are tied to the value of the U.S. CPI and sold by the U.S. Treasury
• In the United Kingdom, inflation-linked gilts are issued by the U.K. Debt Management Office and linked to that country's retail price index (RPI)
• The Bank of Canada issues that nation's real return bonds
• Indian inflation-indexed bonds are issued through the Reserve Bank of India (RBI)

The outstanding principal of the bond generally rises with inflation for inflation-linked bonds. So, the face or par value of the bond increases when inflation occurs. This is in contrast to other types of securities, which often decrease in value when inflation rises.

The interest paid out by inflation-linked bonds is also adjusted for inflation. By providing these features, inflation-linked bonds can soften the real impact of inflation on the holders of the bonds.

History of Inflation-Linked Bonds

Inflation-linked bonds were developed during the American Revolution to combat the corrosive effects of inflation on the real value of consumer goods. Massachusetts issued inflation-indexed bonds beginning in 1780, but inflation indexing seemed unnecessary for established countries on the gold standard.

Most of the world abandoned the gold standard by the 1970s, and rising inflation created a demand for inflation-linked bonds. In 1981, the U.K. began to issue the first modern inflation-linked bonds, or linkers as they are often called.

Other countries followed suit, including Sweden, Canada, and Australia. The U.S. Treasury did not issue inflation-indexed bonds until 1997, and India issued capital-indexed bonds that same year; however, India did not issue fully inflation-indexed bonds, which protect both coupons and principal from inflation, until 2013.

Risks of Inflation-Linked Bonds

While inflation-linked bonds have considerable upside potential, there are also certain risks associated with these assets.

Values

Their value also tends to fluctuate with the rise and fall of interest rates. TIPS and many of their global inflation-linked counterparts do not offer very good protection during times of deflation, which is when prices decline. The U.S. Treasury sets an initial floor for TIPS at par value.

However, the risk is still considerable because there are older TIPS issues that carry years of inflation-adjusted accruals, which can be lost to deflation. This deflation risk caused TIPS to underperform other Treasury bonds during 2008.

Trading and Taxation

This asset type also presents complications in trading and taxation that don't affect other fixed-income asset classes. This is mostly because inflation-linked bonds have two values: the original face value of the bond and the current value adjusted for inflation.

The adjustments of the principal amount are considered annual income for tax purposes. However, investors do not actually receive the adjustments in that year. Instead, they get the larger coupon payments and only receive inflation-augmented principal when the bond matures. Thus, investors may be subject to tax on what's known as phantom income.

The Bottom Line

Despite their complicated nature and potential downside in deflationary periods, inflation-linked bonds are still enormously popular. They are the most trusted investment vehicle to hedge against short-term inflation. The corrosive effect that inflation can have on returns is a strong motivating factor behind the popularity of these bonds.

An additional upside of inflation-linked bonds is that their returns do not correlate with those of stocks or with other fixed-income assets. Inflation-linked bonds are a hedge against inflation, and they also help to provide diversification in a balanced portfolio.