What are inflation- indexed bonds?
Inflation-linked bonds (also known as inflation-indexed bonds or linkers) are bonds where the principal amount, or interest, or both are indexed to inflation. They are structured to negate the inflation risk of an investment.
At the time of principal or interest payout, the nominal interest rate is adjusted for the inflation index as given by the Fisher equation: 1 + real interest rate = (1 + nominal interest rate) * (1 + inflation rate). In other cases, such as the Treasury Inflation-Protected Securities (or TIPS) in the U.S., the principal amount is adjusted for inflation to calculate the effective interest payout each time. If there is inflation, the adjustment is made upward; in deflationary conditions, the adjustment is made downward. This is subject to a threshold limit.
The chart above clearly shows how inflation-indexed bonds (TIPS in this case) provide stable real returns to the investor vis-a-vis regular Treasury even in inflationary conditions. While the fluctuation in real yields from regular Treasury bonds is inversely proportional to inflation, TIPS effectively protect an investor’s real returns.
However, considering the higher nominal yields quoted by Treasury bonds compared to TIPS, investors may want to decide between investing in inflation-indexed bonds and regular Treasuries.
What are Treasuries?
A U.S. Treasury security is a debt financing instrument issued by the federal government, and simply referred to as Treasuries. There are four types of Treasuries:
• Treasury bills (or T-Bills)—mature in a year or less and are sold at a discount as they pay no interest.
• Treasury notes (or T-Notes)—mature in two–ten years, pay bi-annual interest, and have denominations of $1,000.
• Treasury bonds (or T-Bonds)—mature in 20–30 years, pay bi-annual interest, and have a very liquid secondary market.
• TIPS—inflation-indexed bonds, where the principal is adjusted to the Consumer Price Index (or CPI) as a measure of inflation. The principal is adjusted upward with a rise in the CPI and vice versa. The interest on these securities is calculated on the inflation-adjusted principal amount. So, it varies across the term of the security protecting the holder from risk of falling yield in times of rising inflation. These securities are offered with five-year, ten-year, and 30-year tenures.