Inflation-Linked Bonds, a remedy against inflation?

Inflation-linked bonds (or inflation-protected bonds) offer investors protection against a rise in inflation. They are debt issued by governments with an interest rate that depends on the inflation rate directly. Governments issue these bonds because it allows them to decrease their financing costs if inflation falls or remains stable, and investors buy those bonds because it allows them to protect their portfolios against a potential rise in inflation.

What is inflation and why is it a problem for investors?

Inflation is the rate at which prices of goods and services rise in a given economy. 

Inflation is monitored by central banks, who aim to keep the economy stable and sound. Many central banks have a 2% inflation target. They might use various monetary policy tools, such as the monitoring of interest rates or quantitative easing, to either encourage or combat inflation if prices rise too little or too quickly.

However, exogenous events also have an impact on the inflation rate. For example, the COVID-19 pandemic is currently making inflation rise in the U.S. and Europe.

Inflation reduces companies’ and individuals' purchasing power - the amount of something you can buy with a given amount of money. Inflation erodes the value of money, and this affects the interests that bonds will pay in the future as well. This is why when inflation rises, the value of traditional fixed-coupon bonds decreases, and investors’ portfolios lose value (i.e., they lose money).

Inflation-linked bonds in a portfolio

The value of inflation-linked bonds rises as inflation rises. Investors can therefore use inflation-linked bonds to offset the effect of a rise in inflation on their portfolio value.

Inflation-linked bonds can also be used to express views on upcoming changes in inflation. Their value increases as inflation rises. Investors that expect higher inflation rates that the market suggests, can buy inflation-linked bonds at a good price according to their views. Later, if they are right and inflation soars, they can sell their inflation-linked bonds for a gain when inflation numbers come out.

How do inflation-linked bonds work?

To understand how inflation-linked bonds work, let’s take the example of U.S. TIPS (Treasuries Inflation-Protected Securities). In the US, inflation is measured by the Consumer Price Index (CPI), a basket of consumer goods and services. Inflation is calculated by comparing the current year’s CPI with a base year’s CPI.  

When the CPI increases, the coupon (the interest) and principal (the amount lent) increase by the same relative amount. For example, if inflation rises from 2% to 3%, the coupon and principal will be increased by 1% to reflect the impact of the rise of inflation.

This is a very important feature because it means the value of the bond increase in an inflationary environment unlike other types of bonds whose value decrease in such an environment.

What happens in times of deflation?

In periods of deflation (decreasing inflation), coupon payments decrease by the same rate as deflation. So, while inflation-linked bonds hedge investors against inflation risk, they also expose them to deflation risk.

Most inflation-linked bonds are somewhat protected against deflation. This means even if deflation occurs, the amount to be repaid will not decrease below a certain threshold, thanks to this protection (called a floor). Some inflation-linked securities provide protection for both coupons and principal in case of deflation.

However, this protection is limited. For example, a 20-year inflation-linked bond that has accumulated gains due to inflation in the first 10 years, if during the 11th year deflation occurs, part of the gains will be lost. This is because the floors on coupon and principal are set at the initial issue of the bond.

You can use Trackinsight’s ETF screener to find inflation-linked bonds ETFs  and many other instruments.