Most quality investment portfolios allocate at least a small portion of assets to fixed-income securities like bonds to offset stock market risk. Diversification with these assets helps to alleviate the risk of volatility, but they come with a significant drawback. Bonds are a slow-to-grow asset, and in times of high inflation, investors lose purchasing power.
What can investors do about inflation risk?
One way to combat inflation’s effect on your investment portfolio is to consider investing in inflation-protected bonds. As their name suggests, these bonds are designed to alleviate the risk of inflation, helping investors maintain their purchasing power.
What Are Inflation-Protected Bonds?
Inflation-protected bonds are fixed-income securities that work like normal bonds in many respects. Like other bonds, they have a face value (par value) when purchased, generally ranging from $1,000 to $10,000, which is the principal investment the investor makes to own them.
The bonds pay coupon rates or interest rates, periodically returning cash to their holders as a return on their investments. The bonds also have an expiration date or maturity date, generally ranging from one to 30 years. Upon expiration, the bondholder receives back their principal investment along with any accrued but unpaid interest.
What sets inflation-protected bonds apart is the fact that the coupon payments from these bonds fluctuate with inflation, unlike nominal bonds that pay investors a fixed rate.
To create the correlation with inflation, inflation-protected bonds base their interest payments on changes in an underlying benchmark like the Consumer Price Index (CPI) or Retail Price Index (RPI). These price indexes reflect the price changes consumers experience when purchasing everyday goods and services — in other words, inflation.
How Inflation-Protected Bonds Work to Preserve Your Investments
For the most part, inflation-protected bonds work just like standard bonds, with the main difference being the interest payments’ connection to the rate of inflation.
As inflation rises, so too do the payments these bonds yield to their holders. On the other hand, when inflation turns negative (deflation), income payments from these investments shrink to match.
How Returns Are Calculated
The primary draw to inflation-protected bonds is the fact that they protect purchasing power through inflation adjustments, but how do those adjustments work?
Here’s the formula used to determine how the inflation rate changes an inflation-protected bond’s coupon payments.
Coupon payments = (((face value x coupon rate) + face value) x inflation rate) – face value
There are a few steps to working the formula out:
- Figure Out the Unadjusted Coupon Rate. First, multiply the face value of the bond by the base coupon rate. This will give you the unadjusted annual return of the bond.
- Add the Face Value Back to the Total. Now, add the face value of the bond to the total from Step 1.
- Determine the Rate of Inflation.To determine the current inflation rate, divide the current reading on the benchmark index (such as the CPI or RPI) by its previous reading. (The U.S. Bureau of Labor Statistics publishes this data monthly.)
- Adjust Returns for Inflation. Now, multiply the result of Step 2 by the inflation rate (the result of Step 3). This gives you the total returns of the bond, including the amount you’ll receive upon maturity in addition to coupon payments.
- Subtract the Face Value. Now, subtract the face value of the bond from the total you came to in Step 4 to determine inflation-adjusted annual coupon rate as it sits at the time of the calculation.
Most inflation-protected bonds pay semiannually, so to determine the amount of each coupon payment, simply divide your annual return by 2.
Examples of Inflation-Protected Bond Returns
Inflation can have positive or negative effects on inflation-protected bonds. Here is an example of how these bonds behave in different situations.
Example of a Positive Inflation Period
Say you purchased a $1,000 one-year inflation-protected bond with a coupon rate of 3% that uses the CPI as its benchmark for inflation. When you bought the bond, the CPI read 260. Upon the first coupon payment at the six-month mark, the CPI read 262. At maturity, the CPI read 265. This shows an uptick in inflation during the 12-month life of the bond.
Calculating the First Coupon Payment
To determine the first coupon payment, multiply the $1,000 face value by the 3% coupon rate, giving you $30. Then add the face value to the total, bringing it to $1,030.
Next, adjust for inflation by dividing the current CPI reading (262) by the previous CPI reading (260), resulting in a value of 1.0077 (a 0.77% rate of inflation). Multiply this rate of inflation by the total value of the bond — or 1.0077 multiplied by $1,030, resulting in a total of $1037.93.
Subtracting the $1,000 face value of the bond gives you an annualized payment of $37.93. Divide this by two and the semiannual payment comes to $18.96.
Calculating the Total Return of the Bond
To calculate the total return of the bond at maturity, start by once again multiplying the bond’s face value by the coupon rate ($1,000 x 0.03 = $30), and adding the face value back to the total, bringing it to $1,030.
Next, divide the ending CPI reading (265) by the starting CPI reading (260), giving you 1.019, or a 1.9% inflation rate. Multiply this by $1,030, bringing the total payment to the investor over the life of the bond to $1,049.57 — a total return of $49.57.
This total return is significantly higher than the $30 you would have gotten from a nominal bond with a fixed 3% coupon.
Example of a Negative Inflation Period
This time, consider the same bond term, coupon rate, and face value, and starting CPI reading as above. But say in this example, at month six, the inflation index fell to 258, and at maturity, it had fallen to 255. How does falling inflation (deflation) affect the returns of an inflation-protected bond?
Calculating the First Coupon Payment
Start by multiplying the face value of the bond by its coupon for a total of $30. Next, add the face value of the bond to the coupon, bringing the total to $1,030.
Now, divide the current 258 reading of the CPI by the previous 260 reading, giving you a value of 0.99. (This reflects a negative inflation rate, or deflation rate, of 1%.)
Now, multiply $1,030 by 0.99 resulting in a total of $1,019.70. Subtracting the face value brings the total annualized, inflation-adjusted coupon payment to $19.70. Divide this by two and the semi-annual coupon payment you can expect to receive is $9.85.
Calculating the Total Return of the Bond
To figure out the total return, multiply the face value of the bond by the coupon rate and add the face value to the total, resulting in a total of $1,030.
Dividing the current 255 CPI reading to the starting 260 reading ends in a total of 0.98, or a deflation rate of 2%. Multiply the total of $1,030 by 0.98, bringing you to a total payment made to the investor over the life of the bond of $1,009.40, or a profit of $9.40.
This gives you a total return of 0.940%, which is far lower than the return of $30, or 3%, that would have been experienced on a nominal bond with a 3% coupon.
Types of Inflation-Protected Bonds That You Can Invest In
There are different types of inflation-protected bonds to choose from. The biggest difference among them is the party that issues them. Here are your options:
Treasury Inflation-Protected Securities (TIPS)
Treasury inflation-protected securities (TIPS) are inflation-protected bonds offered by the United States Treasury and backed by the full faith and credit of the U.S. government.
Treasury securities like TIPS and other government bonds are issued to cover government debts and fund federal projects.
Investors like TIPS because they tend to perform better than traditional bonds in high inflation periods in the United States.
Capital Indexed Bonds (CIBs)
CIBs are just like TIPS. They both have government issuers, but can be issued by different governments. TIPS are CIBs, but not all CIBs are TIPS. Governments around the world issue inflation-protected bonds to cover the costs of their own debts and government projects.
Investors tend to turn to CIBs when inflation rates in Canada are higher than inflation rates in the United States.
Indexed Annuity Bonds (IABs)
Indexed Annuity Bonds (IABs) are like a mix between traditional CIBs and annuities.
Like annuities, IABs are designed to provide long-term, reliable income, generally throughout one’s retirement years. The only difference is that returns on these bonds are calculated based on an inflation benchmark.
IABs pay out like annuities. So both the principal and interest are calculated into regular payments over the term of the investment, rather than the investor simply receiving coupons and a lump sum payment of the face value of the bond at maturity.
IABs are a great way for investors to secure an inflation-adjusted income source for a long period of time.
Pros and Cons of Inflation-Protected Bonds
Like any investment vehicle, inflation-protected bonds come with their fair share of pros and cons. Here are the most important benefits and drawbacks to consider:
Pros of Inflation-Protected Bonds
Inflation-protected bonds have been gaining in popularity because they come with multiple benefits, especially during times of rising interest rates or, in extreme cases, hyperinflation. Here are the biggest perks:
- Inflation Protection. As inflation increases, so too do payments associated with these bonds, meaning investors won’t lose their buying power.
- Volatility Protection. Bonds are often used as volatility protection, but inflation-protected bonds are known to experience even less volatility than traditional bonds.
- Income. Finally, like all bonds, inflation-protected bonds provide investors with reliable income, making them great options for those nearing or enjoying retirement.
Cons of Inflation-Protected Bonds
Although there are plenty of reasons to consider buying inflation-protected bonds, there are also some drawbacks.
- Declines During Deflation. The effect of inflation goes in both directions. When deflation is present, returns of these bonds will be lower than expected. Moreover, if a significant recession takes place, inflation-protected bond investors could lose money.
- Lack of Liquidity. There’s not much demand for inflation-protected securities on the secondary market. If you decide you want to exit your position early, you may have a hard time finding a buyer.
- Slow Growth. As with all income-centric assets, these bonds are slow growers. If you’re looking for more aggressive growth, you’ll be better suited with another asset class.
Should You Buy Inflation-Protected Bonds?
Whether inflation-protected securities are a good buy depends on two key factors: you and the state of the economy.
When it comes to your needs, inflation-protected bonds are low-risk, slow-growth income generators. They’re best for investors nearing or in retirement. They’re also a great way to hedge against risk in your equity holdings.
It’s also important to consider the state of the economy and inflation before diving into these investments. Times of deflation will weigh heavily on returns and significant recessions have the potential to lead to losses.
Pay close attention to economists to determine whether the economy is headed in the right direction and inflation is likely ahead before buying into these bonds.
Consider Buying Inflation-Protected ETFs & Mutual Funds
If you’re not interested in or comfortable with choosing your own individual investments, consider investing in exchange-traded funds (ETFs) and mutual funds centered around bonds, known as bond funds.
Bond funds provide diversified exposure to a wide range of bonds, and some focus specifically on inflation-protected bonds.
When comparing your options, pay close attention to both the past performance of the fund and its expense ratio. The goal is to invest in low-cost bond funds that have a proven history of success in the market.
Inflation-Protected Bond FAQs
Naturally, you might have some questions about inflation-protected bonds. Here are some of the most common:
How Do Maturity Dates Affect Returns?
As with any bond, the length to maturity affects the returns of inflation-protected options. Short-term investments will come with lower return rates, while long-term investments will offer higher return rates.
How Do I Buy Inflation-Protected Bonds?
You can buy TIPS directly from the U.S. government at the TreasuryDirect website. IABs are offered by a wide range of annuity companies. You can purchase bond funds and ETFs on the open market using the brokerage account of your choice.
What Are the Best Inflation-Protected Bond Funds?
There are several bond funds to choose from, each focused on different maturities and strategies. Some of the best providers of inflation-protected bond funds include Vanguard, BlackRock, and Morgan Stanley.
How Often Do Bondholders Receive Interest Payments?
Although IABs tend to pay out monthly, the vast majority of inflation-protected bonds pay out on a semiannual basis (twice per year).
Inflation-protected bonds are a great investment option for the right investor, especially during times of high inflation. Deciding what bonds to buy and when should be a decision based on research. Take the time to learn about the state of the economy and the direction consumer prices are likely headed before investing in these bonds.