Investors can find protection from rising inflation from inflation-linked bonds. Since they are principal indexed, the principal is increased by the change in inflation over time.
Factors That Affect Inflation-Linked Bonds
The Consumer Price Index
In most countries, the consumer price index (CPI) or its equivalent is used as an inflation proxy. In the case of inflation-linked bonds, as the principal amount increases with inflation, the interest rate is applied to this increased amount. This causes the interest payment to increase over time. At maturity, the principal is repaid at the inflated amount. In this fashion, an investor has complete inflation protection, as long as the investor’s inflation rate equals the CPI.
Inflation-Linked Bonds vs. Nominal Bonds
We must compare an inflation-linked bond to a conventional or “nominal” bond to understand it properly. A normal bond pays its coupon on a fixed principal amount. Using the Government of Canada 8% bond maturing in 2023 as an example, we are due 8%, or $8 on every $100 of principal, each year until we are finally repaid our principal of $100 at maturity. Contrast this with the Canadian real return bonds (RRB), the 4.25% maturing in 2021. It pays a 4.25% “real” interest rate or $4.25 on its principal each year. But the principal increases with inflation, which is based on the Canadian CPI. For example, when Canadian inflation, the CPI, was 1.8% in 1995, the principal amount was increased by 1.8%. The 4.25% coupon now generates a payment of $4.60 versus its original payment of $4.25. At maturity, when the Canadian government will repay the principal, the principal amount will have increased as well.
When You Should Buy Inflation-Linked Bonds
By applying a “real” interest rate, or coupon, to the principal amount, an inflation-linked bond protects the investor from unexpected changes in the consumer price index. Normally, bond investors demand an extra “yield premium” or compensation for inflation risk. Since inflation-linked bonds are not exposed to inflation, their yield is lower than normal, or nominal, bonds. As an example, let us say a 30-year Canada bond has a yield of about 7%. The Canadian RRB has a yield of 4.2%. The 2.8% difference between these two bonds reflects the “break-even inflation rate.” This means that inflation would have to average more than 2.8% per year until the maturity of the bond for the inflation-linked bond to do better than another bond of similar term. Investors do not necessarily expect inflation to be as high as 2.8%; since they do not know what the future will bring they are willing to sacrifice some current yield for inflation protection on the principal. Therefore, investors should buy inflation-linked bonds when they believe inflation will be greater than the yield spread between real and nominal bonds.