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How do inflation-linked bonds work?

How do inflation-linked bonds work?
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A major re-occuptaion for all investors right now is how to cope with the impact of higher inflation on portfolios. This problem is particularly acute when considering the fixed income allocation in portfolios. 

Inflation-linked bonds seem like an obvious way to maintain exposure to fixed income while also having some protection from the impact of rising prices on the spending power of the portfolio.

Yet despite that, inflation-linked bond prices have fallen this year to date.

What are inflation-linked bonds?

In simple terms, inflation-linked bonds are only one step more complicated than a standard bond. There is of course a date in which the bond will mature, a cash flow stream (known as the coupon), and a par amount borrowed by the issuer of the bond and later repaid when the bond matures. Inflation-linked bonds are typically issued by governments or companies. 

The complicating factor for inflation-linked bonds is that the par amount borrowed will maintain its purchasing power throughout the bond’s life. This is because it adjusts daily, with the path of inflation.

The coupon also benefits from inflation-linkage as the amount paid (in pound and pence terms) is calculated by referring to the inflation-adjusted principal or par amount. This is different from ordinary bonds where the par amount and the per cent coupons paid on that par amount do not see any uplift to take account of inflation.

At maturity, the amount repaid will compose of the initial par amount plus the increase in inflation. It is this linkage to inflation that makes it different to a conventional bond and provides investors with a very useful tool to have in their kit. 

Inflation-linked bonds issued by governments are large, highly liquid investments that are considered risk-free in terms of counterparty risk. Many governments issue inflation-linked bonds, the largest issuer being the US government where the market is now more than $1.7tn (1.35tn) in size.

Bond exposure

It is therefore relatively easy to broaden an investor’s exposure to different economic environments and consequently different monetary policies. The future path of growth and inflation are highly uncertain at this point – in fact, opinions vary wildly at the moment, so a prudent approach would be to increase diversification across economies, across currencies and across markets.

Exposure to bonds with different features can also be useful. For example, deflation floors may be attractive as they limit the downside risk for the investor in a deflationary environment while still offering useful inflation protection in an environment where inflation is rising. Alternative inflation indices could offer more protection. 

The key benefit, and why we like them so much, is that they can create certainty for the investor, irrespective of how much inflation there may be in the future. The yield to maturity of the bond is fixed in real terms.

In other words, if you buy a bond with a zero real yield to maturity, as you can do in the US currently, you have locked in a real rate of return. This differs from other bonds, which can guarantee only a nominal, or before inflation is considered, yield.