Inflation is a concept used in economics and finance. It refers to the decline in the purchasing power of a currency over a specific period. Usually, inflation can have positive and negative effects in several fields. For investors that have a fixed income source, such as bonds, inflation can be disadvantageous. However, some bonds may adopt according to current inflation.
What is an Inflation-Linked Bond?
Inflation-linked bonds are a type of debt instrument and classify as bonds. However, they are different from nominal bonds in various key regards. Conventional bonds come with a fixed coupon rate, which also includes fixed interest payments. The coupon rate on these bonds may consider inflation expectations to offer investors an attractive investment. However, once investors buy them, the coupon rate stays fixed.
In contrast, inflation-linked bonds come with a guarantee of fixed real returns irrespective of inflation. Once issued, the coupon rate on these bonds do not remain fixed. Instead, they offset any inflation after issuance. Some inflation-linked bonds may adjust the interest payments in line with the realized inflation, while the redemption value remains constant. Some others may continually index the redemption value to incurred inflation and set the real coupons as a percentage of the indexed amount.
How do Inflation-Linked Bonds work?
Inflation-linked bonds follow the cost of consumer goods, measured by an inflation index. The most prevalent among these indexes is the consumer price index (CPI). For every country that issues inflation-linked bonds, the process for calculating the index will differ. As mentioned above, the method of integrating inflation in these bonds also differ.
Usually, the outstanding principal on the bond will rise for inflation-linked bonds to adjust for inflation. Therefore, the bond’s face or par value will increase with an increase in inflation. The interest payments on these bonds will also follow the same pattern and get adjusted for inflation. Therefore, inflation-linked bonds act the opposite of conventional bonds, which decrease in value due to inflation.
Overall, inflation-linked bonds provide investors with an increasing return to compensate for inflation. Through these bonds, investors can get more realistic returns that they can’t get with conventional bonds. Similarly, they offer investors protection against inflation, which most other nominal bonds do not consider. In countries going through a high inflation period, inflation-linked bonds can be highly advantageous.
What are the disadvantages of Inflation-Linked Bonds?
Inflation-linked bonds, although beneficial for investors, also come with some disadvantages. While inflation can increase the returns on these bonds, they also get affected by deflation. In these cases, nominal bonds provide much better returns to investors as their values increase. However, deflation isn't as common in most countries, so the risks may not be high.
Inflation-linked bonds are also a tax disadvantage for investors. With inflation, the value of these bonds increases. Therefore, it causes a difference between the bond's value and its current value. In some jurisdictions, the increase may be a taxable income for investors. However, these are not actual gains that investors make. Therefore, they have to pay taxes on unrealized income.
Conclusion
Inflation-linked bonds guarantee fixed real returns regardless of inflation. These are different from conventional bonds that offer a fixed income. Instead, inflation-linked bonds adjust for the inflation in a country. These bonds can be highly advantageous for investors compared to conventional bonds with fixed returns. However, they also come with some disadvantages.
Originally Published Here: Inflation-Linked Bond
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