Inflation-Protected Securities: An Overview

Inflation-Protected Securities: An Overview

Typically, investors are concerned with the nominal rate of return on their assets, but the real rate of return is more important. So, if someone informed you about a security that guaranteed a real rate of return above inflation while posing no credit risk, you’d be intrigued.

When putting together a portfolio, investors should aim for a higher risk-adjusted return. In order to accomplish so, they must seek out asset classes that are uncorrelated. While fixed-income securities and stocks are the most typical asset classes to mix in a portfolio for this reason, there is another asset class that can provide further diversification with little work and cost.

Inflation-protected securities (IPS) have been steadily increasing in popularity in several developed markets since the early 1980s. On a risk-adjusted basis, no other security measures up.

What Are Inflation-Protected Securities, and How Do They Work?

When you buy a regular bond, you know exactly how much money you’ll get when it matures (assuming there is no default). However, you have no idea what your true rate of return is since you don’t know how much inflation will be during the bond’s life. An IPS, on the other hand, has the opposite effect. Rather than providing a nominal return, the IPS provides a genuine return. So, while you know your real rate of return, you don’t know what your nominal rate of return is. This is due to the fact that you have no idea what the rate of inflation will be during the term of your IPS.

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Inflation-protected securities are structured similarly to regular bonds, with the exception that the interest payments are split into two parts rather than one. First, the principle grows in line with inflation over the life of the IPS, and at maturity, the full accrued principal is paid out.

Second, the payment of the regular coupon is based on a true rate of return. While an IPS coupon is typically lower than that of a traditional bond, the IPS coupon pays interest on the inflation-accrued principle rather than the nominal principal. As a result, both the principal and the interest are shielded from inflation. An IPS’s coupon payments are shown in the graph below.

When Are They More Beneficial Than Bonds?

The best moment to buy an IPS over traditional bonds is when the market expects inflation to rise and whether those predictions are realized. However, rising inflation does not always imply that an IPS will outperform traditional bonds. The price of inflation-protected securities in comparison to regular bonds determines their desirability.

Even if inflation rises in the future, the return on a regular bond may be high enough to outperform the yield on an IPS. For example, if an IPS has a 3 percent real yield and a conventional bond has a 7 percent nominal return, inflation would have to average more than 4% over the bond’s lifetime for the IPS to be a better investment. The breakeven inflation rate is the rate at which neither security is more appealing than the other.

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How Do You Buy Inflation-Protected Securities?

The construction of most IPSs is similar. Many developed-market sovereign governments issue an IPS (for example, TIPS in the United States; Index-Linked Gilts in the U.K.; and Real Rate Bonds in Canada). Individually, through mutual funds, or through ETFs, inflation-protected securities can be purchased. While federal governments are the primary issuers of inflation-protected securities, the private sector and other levels of government also have issuers.

Should Every Balanced Portfolio Include an IPS?

Inflation-protected securities are classified as fixed income in many investment circles, but they are actually a separate asset class. This is due to their low correlation with traditional fixed income and equity returns. This fact alone qualifies them as strong candidates for assisting in the creation of a well-balanced portfolio; additionally, they are the closest thing to a “free lunch” in the investment world. In fact, to reap the most of the benefits of this asset class, you only need one IPS in your portfolio. Because inflation-protected securities are issued by governments, there is no (or very little) credit risk, and so there is no value in diversifying further.

Inflation can be a fixed income investor’s worst enemy, but with an IPS, inflation can become a friend. This is reassuring, especially for those who remember how rising inflation wreaked havoc on fixed income in the 1970s and early 1980s.

Does it appear to be too good to be true?

While the advantages are obvious, there is a risk associated with inflation-protected assets. To truly realize the guaranteed actual rate of return, you must first hold the IPS until it matures. Short-term changes in the real yield, on the other hand, could have a negative impact on the IPS’s short-term return. Some sovereign governments, for example, issue 30-year IPSs, and while this length of IPS can be highly volatile in the short term, it is nevertheless less volatile than a standard 30-year bond from the same issuer.

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Another danger connected with inflation-protected securities is that, because interest on the principal is taxed immediately, inflation-protected assets are better held in tax-sheltered portfolios. Third, they are underappreciated, and price can be difficult to comprehend and assess.

Final Thoughts

Inflation-protected securities, ironically, are one of the most straightforward asset classes to invest in, but they are also one of the most disregarded. Their low correlation with other asset classes and one-of-a-kind tax treatment make them an ideal addition to any tax-advantaged, well-balanced portfolio. Because sovereign government issuers dominate the IPS market, default risk is minimal.

This asset class does come with its own set of hazards, which investors should be aware of. Longer-term difficulties might have a lot of short-term volatility, putting the guaranteed rate of return in jeopardy. They might also be difficult to comprehend due to their complicated structure. However, there is an almost “free lunch” out there in the investment world for those who are ready to do their study. Get your hands dirty!

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