To reduce their exposure to stock market volatility, the majority of high-quality investment portfolios own some bonds or other fixed-income products. While diversifying into these assets might help reduce exposure to market swings, doing so comes with a major caveat. Investment bonds offer a poor rate of return and can even cause investors to lose money during periods of strong inflation.
How can they protect themselves from inflation? Inflation-proof bonds are one option for reducing the impact of inflation on your portfolio. Such bonds are created to protect holders from price increases, as their name implies, and hence allow holders to keep more of their money over time.
What Are Bonds With Inflation Protection?
It’s true that inflation-protected bonds function similarly to regular bonds in terms of fixed income. The principal investment made by the buyer is equal to the face value (par value) of the bond when purchased, which is typically between $1,000 and $10,000.
Bondholders receive a monetary return on their investment in the form of interest or coupon payments at regular intervals from the issuance of the bonds. The bonds also have a maturity or expiration date, which is specified in years and can be anything from one to thirty.
At the maturity date, bondholders are entitled to receive their initial original investment back, plus any interest that has accrued but not yet been paid. In contrast to nominal bonds, which pay a fixed interest rate to investors, inflation-protected bonds have coupon payments that rise and fall in tandem with inflation.
Inflation-protected bonds are debt instruments whose interest payments fluctuate in value in tandem with an underlying benchmark, such as the Consumer Price Index (CPI) or Retail Price Index (RPI), which tracks general price increases or decreases (RPI).
Inflation, as measured by these price indices, is the general increase in the cost of goods and services that people must pay for on a regular basis.
How to Protect Your Investments with Inflation-Protected Bonds
Inflation-protected bonds function similarly to traditional bonds, with the primary distinction being that the interest payments are tied to the rate of inflation. These bonds yield payments to investors that rise in tandem with inflation. When inflation turns into deflation, however, the income from these investments shrinks as well.
How to Calculate Returns
The main allure of inflation-protected bonds is that they safeguard buying power through inflation adjustments; but how are those adjustments calculated? The coupon payments of an inflation-protected bond are calculated using the following formula.
Payments on coupons equal (face value x coupon rate + face value) x face value) minus face value) inflation rate
The steps in deducing the formula are as follows:
- Determine the Coupon Rate Without Adjustments. To calculate the bond’s yield, first, multiply its face value by the coupon rate. By doing so, you can calculate the bond’s yearly return in its raw form.
- Replace the Total with the Face Amount. Adding the bond’s face value to the sum from Step 1 yields the bond’s total price.
- The Inflation Rate Must Be Calculated. An inflation rate can be calculated by dividing the most recent value of a benchmark index (like the CPI or RPI) by the value calculated one year ago. This information is updated regularly by the BLS (United States Bureau of Labor Statistics).
- Make a Profit after Inflation! Take the sum from Step 2 and multiply it by the inflation rate (the result of Step 3). In addition to the coupon payments, this displays the full bond’s return during its life.
- Reduce the nominal value by the subtraction sign. Step 4: Deduct the bond’s face value from the sum obtained in Step 3 to get the current inflation-adjusted yearly coupon rate.
Since the coupon payments on most inflation-protected bonds are made twice a year, you can easily calculate the amount of each payment by dividing your yearly return by 2.
Returns on Bonds Protected against Inflation Examples
Inflation-linked bonds can profit or lose value depending on the direction of inflation. See how these bonds react in this illustration of their versatility.
Typical Positive Inflation Period
Allow me to illustrate with an example: let’s say you invested $1,000 in a 1-year inflation-protected bond that pays a 3% coupon rate indexed to the CPI. When you purchased this bond, the Consumer Price Index was 260.
At the six-month point, when the first coupon payment was made, the Consumer Price Index was 262. The CPI at age 50 was 265. This demonstrates that there was an increase in inflation over the bond’s term of 12 months.
Making the First Coupon Payment Calculation
Multiplying the face value of $1,000 by the coupon rate of 3% yields the initial coupon payment of $30. The sum is $1,030 once the face value is added in.
The next step is to account for inflation by dividing the latest CPI (262 ) by the previous CPI (260 ), yielding a rate of inflation of 0.77% (1.0077). Applying this inflation rate multiplier to the bond’s face value of $1,000 yields $1037.93.
After deducting the bond’s $1,000 face value, the annualized payment is $37.93. If you break that number in half, you get $18.96 per six months.
How to Determine the Bond’s Total Return
You may estimate how much you’ll get back from this bond if you hold it to maturity by first multiplying its face value by its coupon rate ($1,000 x 0.03 = $30), then adding back the bond’s face value ($1,000), for a grand total of $1,030.
The final CPI value of $265 divided by the initial CPI reading of $260 yields a rate of inflation of 1.019 or 1.9%. The bond’s investor will receive $1,030 in interest payments over the course of its term, yielding a total return of $49.57 if the bond’s face value is $1,000.
You would have received $30 less if you had invested in a nominal bond with a fixed interest rate of 3% instead of this total return.
An Example of a Period of Negative Inflation
Assume the same bond term, coupon rate, face value, and initial CPI as before. However, let’s pretend that the inflation index dropped from 258 to 255 between months 6 and 12 of this example. To what extent does deflation (falling inflation) impact the returns on an inflation-protected bond?
Making the First Coupon Payment Calculation
To get this amount, we must first increase the bond’s face value ($30) by its coupon. The next step is to calculate $1,030 by adding the bond’s face value and coupon together. The current CPI reading of 258 divided by the prior CPI reading of 260 yields a value of 0.99.
This represents a deflation rate of 1%, as opposed to positive inflation. Let’s see how we may get from $1,030 to $1,019.70 by multiplying by 0.99. After deducting the face value, the annualized, inflation-adjusted coupon payment is $19.70. If you divide that number by two, you get $9.85 as your semiannual coupon payment.
How to Determine the Bond’s Total Return
Multiplying the bond’s face value by the coupon rate and then adding the face value yields a total return of $1,030. A deflation rate of 2% can be calculated by dividing the current CPI of 255 by the initial CPI of 260, yielding a result of 0.98.
Taking the present value of $1,030 and multiplying it by 0.98 yields a future payment to the investor of $1,009.40 ($9,40 net profit). When compared to the $30 return, or 3%, you would have received on a nominal bond with a 3% yield, your total return is 0.940%.
Bonds that Protect Against Inflation You Can Invest In
Inflation-proof bonds come in a variety of forms. The party that issues them is the primary determinant of difference.
Your choices are as follows:
Treasury Securities With Inflation Protection (TIPS)
The United States Treasury offers inflation-protected bonds called Treasury Inflation Protected Securities (TIPS), which are backed by the full faith and credit of the United States government.
Bonds and other Treasury securities are issued to finance federal programs and pay off government debt. In times of high inflation in the United States, investors favor TIPS over conventional bonds due to their superior performance.
Bonds with capital indexes (CIBs)
Similar to TIPS, CIBs are safe investments with low volatility. They’re both issued by governments, however, they might be different ones. Some CIBs are not also TIPS.
Inflation-safe bonds are issued by governments all over the world to help pay for public works and other obligations. Investors often choose CIBs when Canadian inflation rates are greater than U.S. inflation rates.
Indexed Annuity Bonds (IABs)
You might think of Indexed Annuity Bonds (IABs) as a cross between a conventional CIB and an annuity. IABs, much like annuities, are meant to offer a steady stream of income for a lengthy period of time, typically throughout retirement. Inflation is used as a basis for determining bond returns instead of a standard interest rate.
A payout from an IAB resembles an annuity. Instead of just receiving coupons and a single payment equal to the bond’s face value upon maturity, investors receive payments that include both principal and interest. Investors can hedge against inflation over the long term with IABs.
The advantages and disadvantages of Bonds Protected against Inflation
Inflation-protected bonds, like any other investment product, have both benefits and drawbacks. The primary advantages and disadvantages are as follows:
Advantages of Bonds Protected against Inflation
During periods of rising interest rates or, in extreme circumstances, hyperinflation, inflation-protected bonds have become increasingly popular due to their many advantages.
In particular, below are some advantages:
- Safeguards Against Inflation. Payments on these bonds rise in tandem with inflation, protecting holders against a decline in purchasing power.
- Cushion against market swings. Bonds are commonly employed as a hedge against market volatility, and inflation-protected bonds have even less volatility than standard bonds.
- Income. Last but not least, inflation-protected bonds, like any other bond, offer investors dependable income, making them a good choice for individuals who are either close to or already in retirement.
Disadvantages of Inflation-Protected Bonds
There are a number of benefits to purchasing inflation-protected bonds, but there are also some disadvantages to consider.
- Drops When the Currency Is Deflationary. Inflation can have both positive and negative consequences. In a deflationary environment, bond investors might expect reduced returns. Investors in inflation-protected bonds may also suffer losses in the event of a severe economic downturn.
- The money supply is insufficient. Inflation-linked securities don’t fetch a high price in the secondary market. You might have trouble finding a buyer if you decide to sell your stake in the company before its normal selling time.
- Low Rate of Growth. These bonds are slow to grow, like other income-focused investments. A more risky asset class would be preferable if you’re after rapid expansion.
Should You Purchase Bonds Protected Against Inflation?
You and the economy’s health are the two main determinants of whether inflation-protected securities are worth purchasing. Inflation-safe bonds can provide a steady stream of income with minimal risk. They are ideal for those who are either retired or nearing retirement age.
You can use them to protect your stock portfolio from potential losses. You should think about the economy and inflation rates before making any of these investments. There will be a significant dampening of returns during deflationary periods, and losses may be incurred during severe economic downturns.
Before investing in these bonds, it’s important to keep an eye on economic forecasts to see if the economy is trending upward and if inflation is on the horizon.
Invest in Inflation-Protected Mutual Funds & ETFs
Plays a significant role in bond funds and exchange-traded funds (ETFs) that specialize in bonds if you don’t want to or feel comfortable selecting your own individual assets. Bond funds give investors access to a variety of bonds, and some of them specialize in inflation-protected bonds.
Consider carefully both the fund’s historical performance and its expense ratio when contrasting your possibilities. The objective is to make investments in low-cost bond funds with a track record of market success.
For the proper individual, inflation-protected bonds are a fantastic investment choice, particularly when inflation is high.
Research should be used to make decisions about what bonds to purchase and when. Before investing in these bonds, take the time to educate yourself about the economic situation and the expected trajectory of consumer prices.