Investments tend to suffer when faced with inflation. This is because high inflation erodes the actual profits, resulting in a reduced overall return. For instance, in November 2022, inflation was around 7%. If your investments yielded 10% during that period, the real returns would be merely 3% after accounting for inflation. While high-yield investments can help counteract the effects of inflation to some extent, certain options, such as inflation-indexed bonds, offer a way to safeguard your portfolio against inflationary pressures.
What is inflation-indexed bonds?
Inflation-indexed bonds or IIBs is a type of bond designed to protect investors from the rising inflation, which is the rise in the overall price level of goods and services in an economy over time. As inflation erodes the purchasing power of money, it can adversely affect individuals and create economic instability. However, these bonds serve as a shield against inflation by offering a fixed rate of return that accounts for changes in the inflation rate. Both the principal amount and interest payments on these bonds are adjusted to maintain their real value, ensuring that investors' investments are safeguarded from the impacts of inflation.
Let us discuss, how IIBs work, their features and benefits, and their potential drawbacks.
How Do Inflation-Indexed Bonds Work?
Inflation bonds work differently than traditional bonds in terms of their interest payments. The principal amount and the interest payments are adjusted for inflation using the CPI (consumer price index). The investor will receive the adjusted principal amount, which ensures that the real value of the investment is maintained. A fixed interest rate is usually set at the time of issuance, which is added to the inflation rate to determine the total interest payment.
Let us take an example to understand how IIBs work:
Suppose an investor purchases an IIB with a face value of Rs. 10,000, a ten-year maturity, and a coupon rate of 3% above inflation.
If the inflation rate is 4% when the bond is issued, the investor will receive an annual interest payment of Rs. 312 (3% of INR 10,400) in the first year.
If the inflation rate increases to 5% in the second year, the investor will receive an annual interest payment of Rs. 327.60 (3% of INR 10,920) in the second year. The coupon rate will remain at 3% above inflation throughout the ten-year tenure.
This process continues until the maturity of the bond, ensuring that the investor receives a fixed income stream that keeps pace with inflation.
If the inflation rate is lower than the fixed interest rate, then the total interest payment would be lower than the fixed rate. On the other hand, if the inflation rate is higher than the fixed interest rate, then the total interest payment would be higher, providing investors with some protection from inflation.
Additional Read: What are different types of bonds
Features and Benefits of Inflation-Indexed Bonds
- Protection against inflation: IIBs provide protection against inflation by adjusting the principal amount and interest payments for inflation, which ensures that the real value of the investment is maintained.
- Issued by the government: IIBs are issued by the central government, which makes them a safe investment option.
- Available in different maturities: IIBs are available in different maturities ranging from 5 to 40 years, which makes them suitable for investors with different investment horizons.
- Fixed rate of return: IIBs offer a fixed rate of return that is adjusted for inflation, which provides investors with a predictable income stream.
- Tradable: IIBs are tradable on stock exchanges, which provides investors with liquidity and the ability to exit their investment before maturity.
How is interest on an inflation-indexed bond calculated?
Inflation-indexed bonds have a principal amount that is linked to inflation, causing the principal value to rise with increases in inflation. The interest payments on these bonds are determined using a formula that considers the current level of deficit finance. Specifically, if inflation is, for example, 3%, and the bond's interest rate is 5%, the interest payment is calculated as 5% of the current principal value plus 3% of the original principal value.
How does an inflation index bond work?
Inflation-indexed bonds operate by adjusting both the principal and interest payments based on changes in the consumer price index (CPI), which measures the average change in prices for a basket of goods and services. The CPI is a key indicator used to calculate the rate of inflation. These bonds, issued by governments to fund budget deficits, offer a hedge against inflation. Interest is paid semi-annually, and the design of these bonds aims to shield investors from the adverse effects of inflation.
How to invest?
Investors can acquire inflation-indexed bonds through various channels, including government websites, banks, and brokerages. In India, the two primary methods for purchasing such bonds are through Inflation Indexed National Saving Securities - Cumulative and Index Funds-ETFs. The Indian government issues these bonds to assist savers in protecting their money from the erosive effects of inflation. Investors have the flexibility to make purchases through banks, brokerages, and online platforms.
Should you invest?
Investing in inflation-indexed bonds, also known as real return bonds, can be a prudent strategy to safeguard your investment against inflation's erosive effects. These bonds are designed to provide returns that adjust with inflation, thereby preserving the purchasing power of your money. By offering a guaranteed rate of return above inflation, they ensure that your investment grows in real terms.
However, potential investors should be aware of certain risks. Inflation-indexed bonds are typically issued by governments, exposing them to political risks similar to other government debt. Moreover, these bonds often yield lower interest rates compared to traditional bonds, which may limit income from interest payments.
Despite these considerations, inflation-indexed bonds can diversify and strengthen a portfolio, especially during periods of rising inflation. They offer a unique hedge against inflationary pressures and provide stability in preserving the real value of your investments over time. As with any investment decision, it's crucial to assess your financial goals, risk tolerance, and overall portfolio strategy before investing in inflation-indexed bonds.
Drawbacks of Inflation-Indexed Bonds
- Low yields: Inflation bonds tend to have lower yields than regular bonds, which can reduce their attractiveness to investors.
- Limited availability: Inflation-indexed bonds are not as readily available as regular bonds, which can make it difficult for investors to diversify their portfolios.
- Market risk: There is still a degree of market risk associated with investing in inflation-indexed bonds, as fluctuations in interest rates and other economic factors can affect their prices.
- Liquidity risk: Inflation-indexed bonds may have lower liquidity than regular bonds, which can make it difficult for investors to sell their holdings when they need to.
- Counterparty risk: There is a risk that the issuer of the inflation-indexed bonds may default on their obligations, which can result in losses for investors.
Conclusion
In summary, inflation-indexed bonds can help them maintain their purchasing power over time. These bonds work differently than conventional bonds because their principal amount and interest payments are adjusted for inflation. Although IIBs come with some drawbacks, their benefits outweigh the negatives, making them a desirable investment option.
Investors should consult with a financial advisor or do their research before investing in these bonds to understand their risks and suitability in their investment portfolio. They shall also require a Demat account to hold their investments in an electronic format.
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