There are several asset types that have the potential to beat inflation, but if you're looking for a financial instrument that does so in a low-risk and predictable way, inflation-linked bonds may be a sensible addition to your investment portfolio in times of high inflation. In this article, we'll explain how inflation-linked bonds work and how you can buy them.
- The principal of inflation-linked bonds is adjusted regularly for inflation
- This preserves the real value of your investment if prices across the economy rise
- You can buy inflation-linked bonds directly from governments or through an online broker
- Inflation-linked bonds don't always offer superior yields, and lose value in times of deflation
How do inflation-linked bonds work?
Unlike regular bonds, which have a fixed principal, the principal of inflation-linked bonds is adjusted regularly for inflation. For example, if the annual inflation rate is 5%, the principal of a $1,000 bond will rise to $1,050 over the course of a year. Interest payments will also rise at the rate of inflation - so if this bond pays 2% interest, the actual interest payment you receive will rise from $20 to $21.
An example - US TIPS
Perhaps the best-known example of an inflation-linked bond is TIPS, or Treasury Inflation-Protected Securities, issued by the US government. TIPS can have a maturity of 5, 10 or 30 years, and can be bought in increments of $100. The principal is adjusted monthly using the CPI-U inflation index of the US Bureau of Labor Statistics, which measures changes in the living costs of US urban consumers. TIPS pays interest every six months; the interest rate is fixed in percentage terms and therefore rises (or falls) in tandem with the inflation rate and the bond principal.
In general, inflation-linked bonds are typically issued by national governments, and are available to retail investors in many countries globally. Some other notable examples of inflation-linked bonds include Treasury I savings bonds in the US, index-linked gilts in the UK and real-return bonds (RRBs) in Canada.
New to the bond market? Find out what bonds are in our detailed guide.
How to buy inflation-linked bonds?
Similarly to regular government bonds, there are two basic ways to buy inflation-linked bonds:
You can buy them on the primary market - that is, directly from the relevant government agency (such as the TreasuryDirect service of the US government) when the bond is first issued.
Alternatively, you can buy them on the secondary market, where bonds are bought and sold ahead of maturity. (Some inflation-indexed bonds, such as I bonds in the US, can't be traded on the secondary market.)
The best way to tap into the secondary market for inflation-protected bonds is through an online broker. Many online brokers in the US charge no fees for the trading of US government bonds, and also come with no annual account fees, withdrawal fees or inactivity fees.
The best brokers for bonds include TD Ameritrade , Charles Schwab and E*TRADE in the US; and Interactive Brokers , CapTrader and flatex in Europe. For more information and alternatives, check out the full list of the best brokers for bonds in your country.
Pros, cons and risks of inflation-linked bonds
When held to maturity, the value of an inflation-linked bond is guaranteed to keep up with inflation, as are its regular interest payments. This can give you peace of mind compared with other asset types - such as stocks - that generally beat inflation in the long run but are subject to more short-term volatility and can lose value over your specific investment time horizon.
However, when traded on the secondary market, the market value of inflation-linked bonds can rise or fall in the short term, depending on the interest rate environment and market-moving news.
Also, inflation-indexed bonds don't necessarily outperform regular bonds in times of steady and predictable inflation. This is because nominal interest rates on regular government bonds already factor in expected inflation, and as such are typically higher than those on inflation bonds. It is when inflation unexpectedly rises over your investment horizon that inflation-linked bonds can outperform normal bonds.
Inflation-linked bonds obviously do not perform well during times of deflation - that is, when prices across the economy are falling. To partially protect you from the negative impacts of deflation, many inflation-linked bonds have a so-called "deflation floor". For example, in the case of TIPS, you are guaranteed to get back the bond's face value upon maturity, even if the principal would have fallen below face value as a result of deflation.
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