Hedge your bets with inflation index bonds

Inflation will have a depressing effect on fixed income investment, reducing its purchasing power and reducing its real return over time. This happens even if the inflation rate is relatively low. If your portfolio has a return of 9% and an inflation rate of 3%, then your actual return is about 6%. Inflation index-linked bonds help hedge against inflation risks because they will appreciate during periods of inflation.

Key points

  • Inflation index-linked bonds help hedge against inflation risks because they will appreciate during periods of inflation.
  • The United States, India, Canada and many other countries all issue inflation-linked bonds.
  • In a period of deflation, TIPS and many of its peers linked to global inflation did not provide good protection.
  • Another benefit of inflation-linked bonds is that their returns have nothing to do with the returns of stocks or other fixed income assets.

The United States, India, Canada and many other countries all issue inflation-linked bonds. Because they reduce uncertainty, inflation index bonds are popular long-term planning investment tools for individuals and institutions.

How inflation-linked bonds work

Inflation-linked bonds are linked to the cost of consumer goods as measured by inflation indices, such as the Consumer Price Index (CPI). Each country has its own method of calculating these costs on a regular basis. In addition, each country has its own agency responsible for the issuance of inflation-linked bonds.

In the United States, Treasury inflation-preserving securities (TIPS) and inflation index savings bonds (I bonds) are linked to the value of the U.S. CPI and sold by the U.S. Department of the Treasury In the UK, inflation-linked Phnom Penh bonds are issued by the UK Debt Management Office and are linked to the country’s retail price index (RPI).Bank of Canada issues the country’s real return bonds, while India’s inflation index bonds are issued through the Reserve Bank of India (RBI).of

Generally speaking, the outstanding principal of bonds of inflation-linked bonds rises with inflation. Therefore, when inflation occurs, the face value or face value of the bond will increase. This is in contrast to other types of securities, which usually depreciate when inflation rises. The interest paid on bonds has also been adjusted for inflation. By providing these functions, inflation-linked bonds can reduce the actual impact of inflation on bondholders.

The risks of inflation-linked bonds

Although inflation-linked bonds have considerable upside potential, they also carry certain risks. Their value also tends to fluctuate with the rise and fall of interest rates. In a period of deflation, TIPS and many of its peers linked to global inflation did not provide good protection. The U.S. Treasury Department sets an initial lower limit for TIPS.However, the risk is still considerable because of the old TIPS issue with multi-year inflation-adjusted accruals, which may be lost due to deflation. This risk of deflation caused TIPS to underperform other Treasury bonds in 2008.

TIPS also has complications in terms of transactions and taxes that do not affect other fixed income asset classes. This is mainly because bonds linked to inflation have two values: the original face value of the bond and the current value adjusted for inflation. For tax purposes, the adjustment of principal is considered as annual income. However, investors did not actually receive an adjustment that year. Instead, they get a larger face-to-face payment and only receive the inflationary increase in principal when the bond matures. Therefore, investors may need to tax the so-called phantom income.

The history of inflation-linked bonds

Inflation-linked bonds were developed during the American Revolution to combat the erosion of inflation on the actual value of consumer goods. Massachusetts began issuing inflation index bonds in 1780, but for mature countries with a gold standard, inflation index seems unnecessary.

By the 1970s, most parts of the world had abandoned the gold standard, and rising inflation created new demand for inflation-linked bonds.In 1981, the United Kingdom began to issue the first modern inflation-linked bonds or bonds commonly referred to as “linkers.”Other countries have followed suit, including Sweden, Canada and Australia. The U.S. Treasury Department did not issue inflation index bonds until 1997, and in the same year India issued capital index bonds.However, it was not until 2013 that India issued bonds fully linked to inflation to protect the coupon and principal from inflation.

Bottom line

Despite their complex nature and potential downside risks during deflationary periods, inflation-linked bonds are still very popular. They are the most trusted investment tools to hedge short-term inflation. The corrosive effect of inflation on returns is a powerful driver behind the popularity of these bonds. Another benefit of inflation-linked bonds is that their returns have nothing to do with the returns of stocks or other fixed income assets. Inflation-linked bonds are tools to hedge against inflation. They also help diversify a balanced investment portfolio.

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