Adding to the toolkit: inflation-linked bonds
When looking to mitigate against the effects of inflation, inflation-linked bonds can be an important tool in an investor’s kitbag. Knowing how they work and what they can do is, therefore, important.
Inflation-linked bonds help against inflation risk because they link a bond’s principal value (the amount to be paid at the end of the bond’s life) to the price index such as CPI that reflects the rate of inflation. As a result, inflation-linked bonds are more than a coupon strategy as indexation to inflation is impacting the bond’s principal that as a result grows over time.
If inflation is 2%, the principal value of an inflation-linked bond will increase by 2% each year until the bond matures. This process is known as inflation indexation.
In practice, if an investor had bought an US inflation linked bond in 2000 and held it until today1 , its principal would have increased to 173, providing a cushion to the real value of the investment. In the case of a nominal bond of the same characteristics the repayment would have been 100.
Alongside this, as coupons are paid based on a percentage amount of the principal, the coupon payments will also increase. This is how inflation-linked bonds can help investors mitigate the impact of inflation on their portfolios, acting as a shock absorber the real value of their assets
Providing a real yield for investors
On top of this, as inflation indexation is guaranteed by the issuer, inflation-linked bonds also provide investors with a real yield. Real yields represent the premium that investors can lock-in on top of realized inflation.
The real yield added to the inflation indexation forecast will give the equivalent to a running yield that could be compared to the yield of a nominal bond. This calculation is known as the total income of an inflation linked bond.
As this chart shows, in most cases inflation is published monthly so the income is not a straight line and would differ from one month to another. This also demonstrates that high inflation should mean high income for inflation-linked bonds.
Inflation can erode the real returns of investments however tools like inflation-linked bonds could help investors mitigate the effects of inflation on their portfolio.Find out more
Watch the other modules from our inflation series
The objective of this series is to make inflation-linked bonds investing simple to investors.