Inflation indexed bonds

What Are Inflation Indexed Bonds?

Inflation indexed bonds are a type of fixed income security designed to protect investors from the erosive effects of inflation, which is the general rise in prices for goods and services over time. Unlike traditional bonds that pay a fixed coupon, the principal value of inflation indexed bonds is adjusted periodically based on changes in a specific inflation index, most commonly the Consumer Price Index (CPI). This adjustment ensures that the bond's underlying value, and consequently its interest payments, keeps pace with changes in the cost of living. At maturity, the investor receives either the original or the inflation-adjusted principal, whichever is greater, offering a safeguard against loss of purchasing power.

History and Origin

The concept of inflation-indexed securities dates back to the late 18th century, with some of the earliest recorded issues by the Commonwealth of Massachusetts in 1780 during the Revolutionary War. However, the modern global market for inflation indexed bonds, often called "linkers," gained significant traction much later. The United Kingdom was a pioneer among major developed markets, introducing its inflation-linked bonds in 1981. Several other countries followed suit, including Australia, Canada, Mexico, and Sweden.¹⁵

In the United States, the Treasury Department first auctioned Treasury Inflation-Protected Securities (TIPS) on January 29, 1997, with a 10-year maturity.¹³, ¹⁴ This introduction provided U.S. investors with a direct tool to hedge against inflation, a concern that had been highlighted by periods of high inflation in prior decades.¹² The U.S. government expanded its TIPS offerings over time, introducing 5-year notes in June 1997 and 30-year bonds in April 1998, with varying issuance schedules and maturities evolving through the years.¹¹ The primary purpose of issuing these inflation indexed bonds was to reduce the U.S. Treasury's long-term financing costs and broaden its investor base.¹⁰

Key Takeaways

• Inflation indexed bonds adjust their principal value in response to changes in an inflation index, typically the Consumer Price Index (CPI).
• This adjustment helps preserve the investor's purchasing power by ensuring both principal and interest payments grow with inflation.
• These bonds offer a "real" yield (return after inflation), making them attractive for investors seeking inflation protection.
• The U.S. government issues inflation indexed bonds known as Treasury Inflation-Protected Securities (TIPS).
• Investors are guaranteed to receive at least their original principal amount at maturity, even if there is deflation.

Formula and Calculation

The calculation for inflation indexed bonds involves two main components: the adjustment of the principal and the subsequent calculation of interest payments.

1. Principal Adjustment: The bond's principal (or par value) is adjusted by an "index ratio" linked to the CPI. The index ratio reflects the cumulative inflation since the bond was issued. $$\text{Adjusted Principal} = \text{Original Principal} \times \text{Index Ratio}$$
2. Interest Payment: The fixed coupon rate is applied to the adjusted principal amount, not the original principal. Since the principal increases with inflation, the dollar amount of the interest payment also increases. Interest is typically paid semi-annually. $$\text{Semi-Annual Interest Payment} = (\text{Adjusted Principal} \times \text{Coupon Rate}) \div 2$$

For example, if an investor holds a $1,000 par value inflation indexed bond with a 1% coupon rate, and inflation causes the principal to adjust to $1,020, the semi-annual interest payment would be ($1,020 * 0.01) / 2 = $5.10. If inflation rises by 2%, the $1,000 principal would be adjusted upward to $1,020, and the 1% coupon rate would then be applied to the $1,020, resulting in an annual interest payment of $10.20 instead of $10.00.

Interpreting the Inflation Indexed Bond

When interpreting inflation indexed bonds, investors often focus on their "real yield" and the "breakeven inflation rate." The real yield represents the return an investor receives above inflation. For instance, if a TIPS has a real yield of 0.5%, the investor expects to earn 0.5% more than the rate of inflation over the bond's life.

The breakeven inflation rate is a key metric derived by comparing the yield of an inflation indexed bond to a nominal (non-inflation-adjusted) bond of similar maturity. It is calculated by subtracting the real yield of the inflation indexed bond from the nominal yield of a comparable nominal bond.⁹ For example, if a 10-year nominal Treasury bond yields 4% and a 10-year TIPS yields 1.5%, the breakeven inflation rate is 2.5% (4% - 1.5%). This means that if average inflation over the next 10 years is greater than 2.5%, the inflation indexed bond would theoretically provide a better real return than the nominal bond. Conversely, if inflation is less than 2.5%, the nominal bond would perform better. This rate reflects the market's expectation of future inflation and can guide investment decisions.

Hypothetical Example

Consider an investor purchasing a newly issued $10,000 inflation indexed bond with a 0.50% coupon rate and a 10-year maturity.

Year 1:

• Initial Principal: $10,000
• Assume inflation for the year is 3.0%, as measured by the CPI.
• The principal is adjusted: $10,000 * (1 + 0.03) = $10,300.
• First semi-annual interest payment: ($10,300 * 0.0050) / 2 = $25.75
• Second semi-annual interest payment: Assuming no further inflation adjustment within that specific six-month period, it would also be $25.75.

Year 2:

• Beginning Principal: $10,300
• Assume inflation for this year is 2.0%.
• The principal is adjusted again: $10,300 * (1 + 0.02) = $10,506.
• First semi-annual interest payment: ($10,506 * 0.0050) / 2 = $26.265
• Second semi-annual interest payment: $26.265

This example illustrates how both the principal and subsequent interest payments increase in step with inflation, protecting the investor's real value. If, instead, there was deflation and the adjusted principal fell below the original principal, the investor would still receive the original $10,000 at maturity.

Practical Applications

Inflation indexed bonds serve various practical applications for investors and institutions seeking to mitigate inflation risk within their portfolios. They are commonly used in:

• Retirement Planning: Individuals nearing or in retirement often rely on a steady stream of income. Inflation indexed bonds can help ensure that their fixed income investments maintain their purchasing power throughout their retirement years, protecting against unexpected rises in the cost of living.
• Pension Funds and Endowments: These large institutions frequently hold inflation indexed bonds to meet future liabilities that are often linked to inflation, such as pension payments or maintaining the real value of an endowment. This helps with asset-liability management.⁸
• Portfolio Diversification: Adding inflation indexed bonds can provide diversification benefits to a portfolio, particularly when inflation is a concern. They tend to perform well when unexpected inflation materializes, which may offset losses in other fixed-income assets that are more vulnerable to rising prices.⁷
• Government Financing: Governments issue these bonds to reduce their long-term borrowing costs and attract a broader base of investors, including those specifically seeking inflation protection.
• Investment Funds: Many mutual funds and exchange-traded funds (ETFs) specialize in inflation indexed bonds, allowing investors to gain exposure to these securities without directly purchasing individual bonds.⁴, ⁵, ⁶

Limitations and Criticisms

Despite their inflation-protection benefits, inflation indexed bonds have certain limitations and criticisms:

• Lower Nominal Yields: Inflation indexed bonds typically offer lower stated coupon rates and therefore lower nominal yields compared to conventional bonds of similar maturity when inflation expectations are low. This is because part of their return comes from the principal adjustment. If actual inflation turns out to be lower than market expectations, or even negative (deflation), the investor might have earned more from a traditional bond.
• Taxation on Phantom Income: In some jurisdictions, including the U.S., the annual increase in the principal value of inflation indexed bonds due to inflation adjustments is taxable in the year it occurs, even though investors do not receive this amount until the bond matures or is sold. This "phantom income" can create a tax liability without a corresponding cash flow, especially if the bonds are held in a taxable account.
• Short-Term Volatility: While designed for long-term inflation protection, inflation indexed bonds can experience price volatility in the short term, particularly due to changes in real yields or market sentiment regarding future inflation. Their returns have not always tracked inflation closely over shorter periods. For example, during some periods, the Bloomberg US TIPS index has underperformed inflation significantly.³ Some investors on forums like Bogleheads discuss how TIPS might not always outperform nominal bonds if inflation surprises to the downside.²
• Deflation Risk: Although inflation indexed bonds guarantee that the investor will not receive less than their original principal at maturity, periods of sustained deflation can cause the principal and interest payments to decrease, leading to lower nominal returns during those times.

Inflation Indexed Bonds vs. Nominal Bonds

The primary distinction between inflation indexed bonds and nominal bonds lies in how they address inflation risk.

Investors often confuse the two because both are types of fixed income securities issued by governments or corporations. However, nominal bonds pay a fixed interest rate on a fixed principal amount, meaning their future cash flows are set at the time of issuance. If inflation unexpectedly rises, the purchasing power of these fixed payments diminishes. Inflation indexed bonds, on the other hand, actively adjust their principal and thus their interest payments to compensate for inflation, aiming to preserve the investor's real return. The choice between the two often depends on an investor's inflation expectations and their need for inflation protection.

FAQs

Are inflation indexed bonds always a good investment?

Not always. While they offer protection against rising inflation, their performance depends on actual inflation rates compared to market expectations. If inflation is lower than anticipated, or if there's deflation, nominal bonds might offer a better return.

How do inflation indexed bonds protect against inflation?

The principal value of the bond is regularly adjusted based on a consumer price index. This means that both the bond's underlying value and the interest payments (which are calculated as a percentage of the adjusted principal) increase as inflation rises, preserving your purchasing power.

What is "phantom income" with inflation indexed bonds?

Phantom income refers to the annual increase in the bond's principal due to inflation adjustments. This increase is considered taxable income by the IRS in the year it occurs, even though you don't receive the cash until the bond matures or is sold. This can be a concern if the bonds are held in a taxable brokerage account.

Can you lose money with inflation indexed bonds?

Yes, you can. While the original principal is protected at maturity (you'll never receive less than your original principal amount), the market value of the bond can fluctuate before maturity due to changes in real yields or interest rates. If you sell before maturity, you could receive less than your adjusted principal, or even your original principal if market conditions are unfavorable. Also, if inflation turns out to be lower than market expectations, the overall return on an inflation indexed bond might underperform a comparable nominal bond.¹

Where can I buy inflation indexed bonds?

In the U.S., you can purchase Treasury Inflation-Protected Securities (TIPS) directly from the U.S. Treasury through TreasuryDirect.gov, or through a brokerage firm. They are also available indirectly through mutual funds and exchange-traded funds that invest in these securities.