What it means
A normal bond pays a fixed coupon and returns a fixed principal, so inflation eats into what the money can buy. An inflation-indexed security fixes this by tying the amounts to an index.
If prices rise 4%, the bond's principal is raised by 4%, and the interest, which is a percentage of the principal, rises with it. Governments in many countries issue these bonds.
The United States issues Treasury Inflation-Protected Securities, and the United Kingdom issues index-linked gilts. Because the adjustments follow actual inflation, the investor earns a real return, which is the return after inflation is removed.
The yield on an inflation-indexed bond is quoted as a real yield. Comparing it with the yield on an ordinary bond of the same maturity shows what inflation the market expects.
This difference is called the breakeven inflation rate and is widely watched by central banks and investors. There are some points to watch.
The index used and the delay in applying it vary between countries, and the adjusted principal can be taxed even though it is not paid until maturity in some systems. In periods of falling prices, the principal can shrink, although some designs, including the US version, guarantee at least the original principal at maturity.
For a business, these securities can match liabilities that grow with inflation, such as pensions or long-term service contracts. They are usually seen as low-risk because governments stand behind them, but their prices still move when real interest rates change.
An investor who sells before maturity can therefore gain or lose. Compared with ordinary bonds, indexed securities have lower starting yields, because investors are paying for protection.
The better choice depends on whether actual inflation turns out to be higher or lower than the market expected when the bond was bought.
In practice
Real-world examples.
Example
A retired teacher wants income that keeps pace with rising prices. She buys inflation-indexed government bonds, and each year her interest payment rises with the index. Her buying power is better protected than with a fixed bond. She accepts a lower starting income in exchange.
Example
A pension fund has promised annual benefit increases linked to inflation. Its manager buys long-dated indexed bonds to match the liability. When inflation rises, the bonds' value rises too. The fund's actuary uses the match to reduce the risk of a shortfall.
Example
A university endowment holds 15% of its portfolio in indexed securities as a safeguard. When prices unexpectedly accelerate, this portion keeps its real value while other bond holdings lose out. The investment committee considers the protection worth the lower yield. It reviews the share every year.
Formula
Calculation
Adjusted principal = Original principal x (Index at present / Index at issue)
Suppose an investor buys a bond with a principal of $10,000 and a coupon rate of 2%, when the price index stands at 300. A year later the index is 312.
The index ratio is 312 / 300 = 1.04, so the adjusted principal is 10,000 x 1.04 = $10,400. The annual interest is 2% of the adjusted principal, which is 10,400 x 0.02 = $208, compared with $200 at the start.Case study
Seen in the real world.
Elmwood Insurance is a fictional insurer that sells annuities whose payments rise each year with a price index. The finance team needed assets that would grow in step with those obligations.
It bought $30,000,000 of inflation-indexed bonds with a real coupon of 1.5%. After a year in which the index rose 5%, the adjusted principal was 30,000,000 x 1.05 = $31,500,000, and interest was 31,500,000 x 0.015 = $472,500.
In this illustrative case, the rising asset values and interest income matched the growth in annuity payments, so the insurer's surplus was little changed. The team noted that if prices had fallen, the principal would have decreased in the interim, although they expected to receive at least the original amount at maturity.
Watch out
Common mistakes.
- Assuming the coupon rate rises, when usually the principal is adjusted and the fixed coupon rate is applied to the new amount.
- Believing the bond cannot lose value, when its market price can fall if real interest rates rise.
- Ignoring tax, as adjustments to the principal can be taxable before they are received in some countries, leaving the investor to pay tax from other money.
Questions
People also ask.
How does an inflation-indexed security differ from a normal bond?
Its payments are adjusted for inflation, while a normal bond pays fixed amounts.
Which index is used?
It depends on the issuer, with consumer price indices being the most common, and some issuers use a measure that excludes certain items.
Is it a good investment during deflation?
The principal may shrink, but some bonds guarantee at least the original principal at maturity.
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