Investments tend to suffer when faced with inflation. This is because high inflation erodes the actual profits, resulting in a reduced overall return. For instance, in November 2022, inflation was around 7%. If your investments yielded 10% during that period, the real returns would be merely 3% after accounting for inflation. While high-yield investments can help counteract the effects of inflation to some extent, certain options, such as inflation-indexed bonds, offer a way to safeguard your portfolio against inflationary pressures.
What is inflation-indexed bonds?
Inflation-indexed bonds or IIBs is a type of bond designed to protect investors from the rising inflation, which is the rise in the overall price level of goods and services in an economy over time. As inflation erodes the purchasing power of money, it can adversely affect individuals and create economic instability. However, these bonds serve as a shield against inflation by offering a fixed rate of return that accounts for changes in the inflation rate. Both the principal amount and interest payments on these bonds are adjusted to maintain their real value, ensuring that investors' investments are safeguarded from the impacts of inflation.
Let us discuss, how IIBs work, their features and benefits, and their potential drawbacks.
History of inflation indexed bonds
Inflation-indexed bonds date back to 1780, when the Massachusetts Bay Company issued the first known example. The market gained momentum after the UK began offering inflation-linked Gilts in 1981. By 2019, over $3.1 trillion worth of government-issued inflation-linked bonds existed globally. These instruments are mostly sovereign bonds, with only a small share issued by private entities. The market's growth reflects increasing investor interest in safeguarding capital against inflation across different economies and time periods.
How Do Inflation-Indexed Bonds Work?
Inflation-Indexed Bonds (IIBs) are government bonds that help protect your money from losing value due to inflation. Unlike regular bonds with fixed returns, both the interest and the principal of IIBs go up with inflation, usually based on the Consumer Price Index (CPI). This means your investment keeps pace with rising prices.
Example of Inflation Indexed Bonds
Let us take an example to understand how IIBs work:
Suppose an investor purchases an IIB with a face value of Rs. 10,000, a ten-year maturity, and a coupon rate of 3% above inflation.
If the inflation rate is 4% when the bond is issued, the investor will receive an annual interest payment of Rs. 312 (3% of INR 10,400) in the first year.
If the inflation rate increases to 5% in the second year, the investor will receive an annual interest payment of Rs. 327.60 (3% of INR 10,920) in the second year. The coupon rate will remain at 3% above inflation throughout the ten-year tenure.
This process continues until the maturity of the bond, ensuring that the investor receives a fixed income stream that keeps pace with inflation.
If the inflation rate is lower than the fixed interest rate, then the total interest payment would be lower than the fixed rate. On the other hand, if the inflation rate is higher than the fixed interest rate, then the total interest payment would be higher, providing investors with some protection from inflation.
Types of inflation-indexed bonds
Inflation-indexed bonds are designed to protect investments from inflation. They vary across countries but share the same core objective. Common types include:
Although the core principle behind inflation-indexed bonds is consistent globally—protecting investors from inflation—each country offers its own version:
- Treasury Inflation-Protected Securities (TIPS): Issued by the U.S. government.
- Index-Linked Gilts: The British government's inflation-linked bonds.
- Real Return Bonds: Canada’s version.
- Inflation-Indexed National Savings Securities – Cumulative (IINSS-C): Available in India.
- Capital Indexed Bonds: Issued by various other nations, similar to TIPS.
While structures and adjustment frequencies may vary, their primary purpose remains universal.
Features of inflation-indexed bonds
Inflation-indexed bonds offer several unique features that make them appealing to investors:
- Protection against inflation: IIBs provide protection against inflation by adjusting the principal amount and interest payments for inflation, which ensures that the real value of the investment is maintained.
- Issued by the government: IIBs are issued by the central government, which makes them a safe investment option.
- Available in different maturities: IIBs are available in different maturities ranging from 5 to 40 years, which makes them suitable for investors with different investment horizons.
- Fixed rate of return: IIBs offer a fixed rate of return that is adjusted for inflation, which provides investors with a predictable income stream.
- Tradable: IIBs are tradable on stock exchanges, which provides investors with liquidity and the ability to exit their investment before maturity.
How is interest on an inflation-indexed bond calculated?
Interest on inflation-indexed bonds is calculated by adjusting the principal for inflation and then applying the coupon rate. Here’s a simple example:
- Bond details: Rs. 10,000 principal, 2% annual coupon rate.
- Inflation adjustment: After 6 months, inflation rises by 1.5%, increasing the principal to Rs. 10,150.
- Interest payment: The 6-month interest is calculated as Rs. 101.50 (2% ÷ 2 applied to Rs. 10,150).
This process repeats for each interest period, with the principal adjusting based on inflation.
Benefits of investing in inflation-indexed bonds
Inflation-indexed bonds provide a range of advantages, including:
- Inflation protection: These bonds help maintain your purchasing power by adjusting returns in line with rising prices.
- Real return assurance: Both the principal and interest are inflation-adjusted, offering consistent returns above inflation.
- Low default risk: Issued mainly by governments or top-rated entities, they are considered very safe investments.
- Diversification benefits: Including these bonds in your portfolio can help manage risk during inflationary periods.
- Growing income: As inflation rises, so do the interest payouts, ensuring a stable and increasing income.
- Capital safety: Even in times of deflation, you’re guaranteed to recover at least your original investment.
- High yield during inflation spikes: These bonds can outperform other fixed-income instruments when inflation surges.
- Economic resilience: They offer stability and value retention even in volatile economic environments.
How to invest?
Investors can acquire inflation-indexed bonds through various channels, including government websites, banks, and brokerages. In India, the two primary methods for purchasing such bonds are through Inflation Indexed National Saving Securities - Cumulative and Index Funds-ETFs. The Indian government issues these bonds to assist savers in protecting their money from the erosive effects of inflation. Investors have the flexibility to make purchases through banks, brokerages, and online platforms.
Should you invest?
Investing in inflation-indexed bonds, also known as real return bonds, can be a prudent strategy to safeguard your investment against inflation's erosive effects. These bonds are designed to provide returns that adjust with inflation, thereby preserving the purchasing power of your money. By offering a guaranteed rate of return above inflation, they ensure that your investment grows in real terms.
However, potential investors should be aware of certain risks. Inflation-indexed bonds are typically issued by governments, exposing them to political risks similar to other government debt. Moreover, these bonds often yield lower interest rates compared to traditional bonds, which may limit income from interest payments.
Despite these considerations, inflation-indexed bonds can diversify and strengthen a portfolio, especially during periods of rising inflation. They offer a unique hedge against inflationary pressures and provide stability in preserving the real value of your investments over time. As with any investment decision, it's crucial to assess your financial goals, risk tolerance, and overall portfolio strategy before investing in inflation-indexed bonds.
How to invest in inflation-indexed bonds?
Investing in inflation-indexed bonds is straightforward:
- Through brokers: Many stockbrokers offer inflation-indexed bonds, tradable like regular securities.
- Direct from government: In some countries, these bonds are available directly from the government, such as TIPS via TreasuryDirect in the U.S.
- Mutual funds or ETFs: Investors can access funds specialising in inflation-indexed securities.
- Online platforms: Various online investment platforms provide access.
- Banks: In India, inflation-indexed bonds are often available through banks.
Considerations before investing:
- Minimum investment: Verify if a minimum amount is required.
- Fees: Be aware of any associated charges.
- Holding period: Some bonds may impose restrictions on early exits.
- Tax implications: Consult a tax advisor for clarity on tax treatment.
Drawbacks of Inflation-Indexed Bonds
While offering numerous benefits, inflation-indexed bonds have some limitations:
- Lower starting yields: Compared to regular bonds, IIBs typically offer lower initial interest rates.
- Structural complexity: The inflation-linked adjustments can be difficult to grasp for investors without financial expertise.
- Tax concerns: In some regions, inflation-based principal gains may be taxed as income, reducing net returns.
- Exposure to market risks: Despite inflation protection, IIBs can still be affected by interest rate movements and inflation expectations.
Conclusion
In summary, inflation-indexed bonds can help them maintain their purchasing power over time. These bonds work differently than conventional bonds because their principal amount and interest payments are adjusted for inflation. Although IIBs come with some drawbacks, their benefits outweigh the negatives, making them a desirable investment option.
Investors should consult with a financial advisor or do their research before investing in these bonds to understand their risks and suitability in their investment portfolio. They shall also require a Demat account to hold their investments in an electronic format.
Related Articles
What is Securities Transaction Tax?
Know about after-market orders
What is non-convertible debentures?
