Inflation Linked Bonds

Inflation is typically an experience in the course of the business cycle, but it tends to bleed off your investments slowly with time. Inflation-link bonds cushion you off such an effect since they fully preserve your purchasing power. They give you regular inflation-indexed returns that appeal to investors who need predictability in uncertain economic conditions. In this post, we’ll discuss inflation-linked bonds, how they work, the types available, and how they can help you benefit. 

What is an Inflation-Linked Bond? 

An inflation-linked bond is a bond whose main amount and interest are inflation-indexed. That is, the impact of inflation on increasing the price of goods and services is translated to increased payments on the specific bond. Inflation-linked bonds are designed to protect investors from inflation since inflation slowly erodes their purchasing power over time. 

Whereas traditional bonds pay interest over their term in a fixed amount, the principal value of an inflation-linked bond is stepped up depending on the changes in an inflation index, like the Consumer Price Index (CPI). This means the principal value and interest payments will eventually rise with inflation. When deflation occurs, the bond value is slightly reduced, but most inflation-linked bonds’ structure denies the possibility that the principle can fall lower than its initial value. 

In simple words, an inflation-linked bond safeguards the returns on your money so that they do not erode due to inflation, thereby saving the real value of your money. 

Understanding Inflation-Linked Bonds 

In terms of their basic structure, inflation-linked bonds are very similar to traditional bonds. You buy the bond, collect interest payments, known as coupon payments, and get your principal at maturity. However, inflation-linked bonds are different in their interaction with inflation. 

As an illustration, you purchase an inflation-linked bond with a face value of US$50,000. If the inflation is at 2%, the principal money will now be raised to US$51,000. The interest earned will also be correlated with this higher amount. So, if the bond’s interest rate is 2%, then you earn interest on the increased principle, leading to higher interest collections. 

Let me illustrate the difference between inflation-linked bonds and regular bonds: 

Traditionally-fixed bonds have interest rates fixed on a fixed amount of the principal. The principal and interest are also inflation-proof. 

Inflation-Linked Bonds: Both principal and interest are adjusted according to an inflation benchmark so that, in real terms, the money invested would be perfectly stable during inflation. 

Inflation-linked bonds are very valuable for investors concerned about the eroding impact of inflation on savings. They have the potential to yield an indexed income stream, making them extremely attractive during economic uncertainty or a sharp increase in inflation rates. 

Types of Inflation-Linked Bonds 

Several variations of inflation-linked bonds were created to protect against inflation. Each type was created for a different type of investor to address the problem. The most common among the bonds are inflation-linked bonds issued by government entities, with the corporate variant also available.

a) Government Inflation-Linked Bonds

Government inflation-linked bonds are considered one of the safest investments because they can hedge against risk and hold the security feature of being fully backed by the issuing government’s full faith and credit. These bonds’ value evolves according to a country’s inflation index, such as the Consumer Price Index (CPI) in the U.S. 

For example, Singapore Government Securities (SGS), like TIPS, are inflation-indexed to the rate of that country. The bonds safeguard Singapore investors’ investments from inflation and give them tranquil support from government stability. 

b) Corporate Inflation-Linked Bonds

Besides government-issued bonds, many corporations also issue inflation-linked bonds. Corporate inflation-linked bonds serve the same purpose as their government-issued counterparts but are accompanied by other risks. The risk of corporate inflation-linked bonds is directly aligned with the soundness of the company’s finances when issuing the bond. Corporate inflation-indexed bonds are known to be more than government issues, but there is an accompanying higher measure of credit risk. 

c) Index-Linked Bonds

Coupling the bonds to an inflation measure, such as the CPI, means that the principal and interest payments adjust according to a change in this index. Therefore, index-linked bonds offer an efficient mechanism for returning returns in line with inflation and provide a stable and consistent investment opportunity. 

Advantages of Inflation-Linked Bonds 

One of the most significant benefits linked to inflation-indexed bonds is attractive for investors seeking stable and inflation-protected returns. Here are some main advantages: 

a) Protection Against Inflation

The most significant advantage of inflation-indexed bonds is that they protect you from inflation. As the prices go up, so will the principal and interest payments made on the bond to ensure your return is preserved against inflationary loss. It is very helpful in the period when inflation is on the rise, causing other investments to lose their value in real terms. 

b) Stable and Reliable Income

This provides a stable flow of income that will adjust with inflation and thus serve the investor with a much-needed source of reliable income over the long term. The purchase of such bonds becomes attractive to conservative investors, especially those reaching or close to retirement who need such a dependable income source and even maintain its real value over time. 

c) Low-Risk Investment

TIPS, inflation-linked government bonds, are among the safest investment opportunities. They are essentially insured by the full faith and credit of the issuing government, which means that the risk of default is minimal. For the risk-averse investor, inflation-linked bonds guarantee protection for investments without having to take inordinate risks. 

d) Preservation of Purchasing Power

Inflation-linked bonds help preserve the purchasing power of money over time. Since capital sum and interest payment undergo changes with inflation, the buying power of such a bond protects the increase in prices without destroying them. This is useful to investors wanting financial safety over long durations. 

Examples of Inflation-Linked Bonds 

The following are some of the best-known instances of inflation-linked bonds that are available in global markets: 

a) Treasury Inflation-Protected Securities (TIPS)

TIPS are issued by the U.S. Department of the Treasury and are designed to protect investors against inflation. The principal of TIPS rises with inflation and falls with deflation; it is indexed to the U.S. CPI. Return is guaranteed, as the U.S. government promises to repay the inflation-adjusted principal at maturity. 

For instance, if you put US$50,000 in TIPS and inflation rises by 3%, then the principal becomes US$51,500. From then onwards, interest payments are calculated on the new principal amount. 

b) Singapore Government Securities (SGS)

SGS are inflation-indexed Singapore government bonds. The coupon and principal payments of such bonds are compensated with the inflation index of that country. Therefore, SGS bonds are safe investments that fetch stabilised returns while resisting inflation. 

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