How inflation protected bonds work

What are inflation protected bonds? 

An inflation protected bond is an instrument that enables risk-averse investors to shield their portfolio from the negative impacts of inflation. These bonds are usually acquired directly through national government agencies, with guaranteed interest payments linked to the country’s rate of inflation. At the maturity of the bond, the overall return is inflation-adjusted or the original sum invested, whichever sum is higher. 

If you’re wondering whether inflation protected bonds could be a savvy move to shield your overall investment portfolio from sizeable losses in the event of surging inflation and interest rates, read on as we explain how they work, their pros and cons and the alternative ways to invest in them. 

How does inflation influence an investment portfolio? 

At a time of rampant inflation, volatility is rife in the financial markets. With uncertainty surrounding interest rates, equities are often at risk, particularly growth stocks like big tech, which are heavily impacted by higher costs for borrowing. 

Fixed-income investments aren’t immune from the negative effects of inflation either. For example, bonds that have a fixed return of 5% against a backdrop of 10% inflation are actually providing a negative yield of -5%. The priority for developing a futureproof investment portfolio is to ensure it yields a greater return than inflation, ensuring a positive real-money return. 

How do inflation protected bonds work? 

Inflation linked bonds are debt instruments issued by governments, with the funds used to finance new infrastructure projects or ongoing tasks. 

Bonds usually pay interest against the bond’s principal value. Once the bond reaches maturity, the principal value is realised by the investor. Inflation protected bonds are unique in that their interest payments rise and fall in line with a country’s official rate of inflation. 

In the US, inflation protected bonds are aligned with the value of the U.S. Consumer Price Index (CPI) and these bonds are sold directly by the US Treasury. In the UK, inflation protected gilts are sold by the UK’s Debt Management Office and are tied to the UK’s Retail Price Index (RPI). 

It’s possible to find additional inflation linked bonds issued by major corporations instead of national governments, but these types of instruments are most commonly available via governments. 

What are the benefits of inflation linked bonds? 

One of the biggest upsides to investing in inflation linked bonds is that it’s a convenient hedge against potential risks in other securities. They reduce potential uncertainty within your portfolio. If your equities are losing value during cost-of-living crises and recessions, inflation protected bonds can offer a guaranteed income that breaks even at the very least in real terms. 

Another benefit of an inflation protected bond is that providing inflation meets the market expectations, your returns will be positive. If inflation exceeds market expectations and is even more rampant than expected, inflation protected bonds can prove an even savvier move. Typically, if prices and yields are in line with inflationary expectations, returns from inflation linked bonds are often no better or worse than other fixed-income investment options. However, if inflation is that much greater, they can outperform other fixed-income securities. 

Looking at a long-term average, the performance of inflation protected bonds has typically outperformed other fixed-income bonds. Inflation linked bonds have provided an average annual return of 6%, compared with the average annual return of 4.5% with fixed-income bonds. However, it’s important to be mindful that this is still significantly down on the 9% average annual return from the stock markets.