Inflation-Indexed Bonds

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21 Aug, 2024

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What Are Inflation-Indexed Bonds?

Inflation-indexed bonds, or inflation-linked bonds, are financial securities that protect investors from inflation. They offer fixed interest rates and a regular income over a long period. To adjust inflation, the bond is linked to an index. They aim to provide investors with a hedge against inflation by adjusting the bond's principal and interest payments based on changes in the inflation rate.

Thus, this bond protects overall returns against economic cycles—the market tendency to alternate between highs and lows. However, returns earned from inflation-indexed bond funds are less (compared to other securities). Investors can buy these bonds with 5, 10, or 30-year tenures.

What are Inflation-indexed bonds?

Inflation-indexed or inflation-linked bonds are financial instruments that allow individuals to earn a fixed interest rate over a long period.
There are two types of interest rates: nominal interest rate and the real rate of return. Upon maturity, investors receive the principal amount, real interest, and inflation interest.
TIPS is a popular example of inflation-adjusted bonds. Treasury inflation-protected securities (TIPS) are inflation-linked bonds the US government issues. It is linked to the US Consumer Price Index.

How Do Inflation-Indexed Bonds Work?

The inflation-indexed bond is a financial instrument that yields a fixed and stable income for a long period. In addition, it accounts for the adverse effects of inflation. The value of the bond increases over time. That, too, is at a lower risk than traditional securities.

Before venturing further, let us define bonds first. Bonds are debt instruments issued by governments or corporations. The bond issuers are the borrowers, and the bondholders are the lenders (or investors). Bonds are fixed-income securities; the periodic interest earned by bondholders is called a coupon payment.

Bonds are tradable units; bondholders can sell them in the secondary market. Despite having a par value, bonds can be traded at a discount or premium. It is important to note that bondholders do not own the company they invest in—they have no claim over company profits.

Now, the inflation-adjusted bond differs in characteristics. The inflation-adjusted bond yields two kinds of returns—the real rate of return and the nominal return. The real rate of return is like other bonds. But the nominal return of an inflation-adjusted bond differs from regular bonds. The difference is more obvious when compared to long-term.

As the name suggests, nominal returns from an inflation-adjusted bond fluctuate along with inflation. Thus, investors are protected from inflation losses. In addition, both the principal and interest remain unaffected by inflation.

These bonds expire in 5 to 30 years. They are linked to the inflation index of the country. For example, in the United States, the government uses Consumer Price Index (CPI) to determine the nominal rate of the Treasury inflation-linked bonds. So, if a person buys $1000 bonds during an inflation rate of 3.5%, they will earn a real rate of return of 3% ($30) and a nominal rate of $30.5. Thus, at the end of the year, the investor earns a total of $1060.5.

History

Let us look at inflation-indexed bond history.

Inflation-adjusted bonds were introduced in the late 20th century. In 1971, American economist Milton Friedman brought attention to the Federal Treasury and its debt. He advocated that it was time to repay its debt. The fund's value had decayed due to inflation.

Twenty-six years later (1997), the Treasury released its first inflation-indexed bonds to provide fixed returns despite inflation. These bonds were linked to the Consumer Price Index (CPI). Soon, these bonds were adopted by Sweden, Canada, New Zealand, and the United Kingdom. In 2004, Japan also started issuing inflation-adjusted bonds.

Examples

Let us look at examples of inflation-indexed bonds to comprehend the concept better.

Example #1

Samuel invests in an inflation-linked bond—with a principal amount of $10,000. The US Treasury Bond yields a 4.5% real rate of return.

Now, the nominal rate of return depends on the inflation rate (during the period). Within a few years, the Federal government reported a 3.5% rise in inflation. Thus, by the fifth year, Samuel received the following amount:

Bond Yield = Principal + Real Rate of Return + Nominal Rate of Return
Bond Yield = $10,000 + $350 + $450
Bond Yield = $10,800

Alternatively, if Samuel had opted for conventional bonds, he would have only got principal plus interest.

Example #2

According to Treasury Direct, more than 1,00,000 accounts got created (as of November 2022). All in all, inflation-linked bonds worth $979 million were purchased.

These bonds yield 1.5% interest for a 1-year duration.

How To Buy?

Investors can purchase through two channels—Treasury Inflation-Protected Securities (TIPS) and funds.

#1 - Treasury Inflation-Protected Securities (TIPS)

TIPS is a U.S.-based bond that allows investors to invest directly through the Treasury. First, however, an individual needs to open a bond account with them. Then, investors can purchase bonds worth $10000 electronically. In addition, they can also purchase bonds worth $5000 in paper format.

In addition, investors can purchase inflation-adjusted bonds worth $5000 to earn tax refunds from the Internal Revenue Service (IRS). Federal taxes are imposed on earned interests, but the earnings are exempt from state or local taxes. Further, the earnings are exempt from taxation if the investor uses the amount on education costs.

#2 - Funds

Alternatively, an investor can purchase exchange-traded funds. They can also invest in an index fund operated by a third party. All these alternatives offer the same benefits.

Advantages

Let us look at the advantages of inflation-indexed bonds for a better understanding:

Fixed Rate of Return: Irrespective of inflation, this bond promises to pay a fixed sum of money in interest. As a result, it has become popular in the US.
Protection against Inflation: These bonds offer an umbrella against the adverse effects of inflation. For example, if a person buys an inflation-adjusted bond today, the rate will be applicable for the first six months. After that, the interest rate will change—depending on inflation.
Tax Savings: Investors save on tax expenses. State and local taxes are not applicable; even federal taxes can be avoided if the investor spends the amount on education.

Frequently Asked Questions (FAQs)

Are inflation-indexed bonds taxable?

While other bonds charge taxes on the maturity amount, it is the reverse of inflation-linked bonds. Interest earned is taxable at the federal level. And even those charges can be avoided if the investor is a student.

Who issues inflation-indexed bonds?

Most of the bonds are backed by a government. For example, in the United States, the Treasury issues inflation-linked bonds. Similarly, the Reserve Bank issues such bonds in India.

Are inflation-indexed bonds safe?

Even regular bonds are considered safe investments. In addition, inflation-linked are inflation-proof. Opportunity cost is the biggest drawback of bonds. But this is true for any low-risk, low returns investment.