Inflation-indexed bonds adjust their cash flow to actual inflation levels, providing a real rate of return that matches the nominal interest rate, eliminating inflation risk for both investors and issuers. They are an attractive option for long-term investments in inflationary times. The United States Treasury issues Treasury Inflation Protected Securities (TIPS), which adjust the principal regularly to protect it from inflation-related erosion. Inflation-indexed bonds also provide benefits to sovereign countries, as the real rate is always equal to the nominal rate. Investors generally accept lower declared rates for inflation-indexed bonds in exchange for the elimination of inflation risk, which stimulates investment, research, development, and consumer spending.
An inflation-indexed bond, like a traditional bond, pays interest at preset intervals and returns the original investment once the bond matures. Unlike a conventional bond, however, an inflation-indexed bond links its cash flow to actual inflation levels so that the real rate of return matches the bond’s nominal interest rate. In this way, both investors and issuers forgo the risks of fluctuations in inflation levels in the future. Many industrialized countries, such as the UK and France, offer inflation-indexed bonds to pay off their debt. Inflation poses a greater threat, through the gradual erosion of principal, to a long-term bond rather than a short-term investment, making inflation-indexed bonds an attractive option in inflationary times for the long-term investment.
For example, a ten-year $100 US dollar (USD) conventional bond with a nominal yield of three percent and an inflation forecast of three percent pays a real rate of seven percent. If the actual level of inflation reaches five percent, the investor will receive only two percent per year on his investment. Also, you lose money if the inflation rate doubles to eight percent. With an inflation-indexed bond, on the other hand, the real rate of return is adjusted to eight percent to lock in the three percent nominal rate of return. Even with eight percent inflation, the inflation-linked bond guarantees the three percent rate of return.
The United States Treasury issues notes or bonds called Treasury Inflation Protected Securities (TIPS). With a TIPS bond, the principal itself adjusts regularly to protect it from inflation-related erosion. For example, the principal of a $10,000 US TIPS bond with a nominal yield of four percent and an annual inflation rate of three percent will adjust on the first semiannual payment date to $10,150, with the adjustment to rise of half of the percentage of annual inflation. The interest will then be four percent of the principal adjusted for inflation, $406 USD. In addition, the principal never falls below face value, even if the inflation-adjusted principal theoretically falls below the original investment.
Inflation-indexed bonds also provide benefits to sovereign countries. With traditional bonds, issuers pay higher amounts of interest than they expect to pay when inflation levels fall below the expected level. For example, a 3 percent nominal bond with an inflation forecast of 4 percent pays a fixed real rate of 7 percent. If inflation reaches a real level of two percent, the issuer pays two percent more than it would have to pay to maintain the nominal yield. When governments offer inflation-indexed bonds, the real rate is always equal to the nominal rate.
Investors generally accept lower declared rates for inflation-indexed bonds than for conventional bonds in exchange for the elimination of inflation risk. Consequently, interest rates in the economy remain low. Low interest rates stimulate investment, research, development, and consumer spending. They also reduce the cost of servicing the federal debt.
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