Been bitten by inflation? Here’s how inflation-linked bonds can protect you

Inflation in Canada and in the U.S. remains muted, and interest rates remain near historical lows. Still, inflation can bite fixed-income investors.

If, for example, you have fixed income investments yielding 4 per cent, and inflation runs at 2 per cent on average, your real return is 2 per cent (4-2%).

But there are things you can do to hedge the effects of inflation or even make inflation a friend. One popular investment vehicle is called inflation-linked bonds (ILBs).

How can ILBs protect your nest egg from inflation?

Returns on inflation-protected bonds are pegged to the cost of consumer goods, such as the consumer price index (CPI). That means the principal of the bond and interest payments rise with inflation, cushioning its impacts on your investment.

Say, for instance, you decided to purchase an ILB issued at $1,000 with a fixed annual coupon of 5 per cent. If the inflation rate remains unchanged, the bond will pay you interest of $50 every year.

However, if the CPI rises 2 per cent, the principal will then be adjusted to $1,020, and the annual coupon payment you receive will increase to $51. When the bond matures, its principal will be adjusted for inflation.

What this means is that ILBs can preserve your purchasing power and thus overcome one of the biggest drawbacks of traditional bonds.

ILBs are typically issued by sovereign governments, and each country terms them differently. In the U.S., they are called Treasury Inflation-Protected Securities (TIPS) and are linked to the country’s CPI. In Canada, the central bank issues Real Return Bonds (RRBs) and ties them to the All-items CPI .

But ILBs are more than just a tool to hedge against rising prices. Despite being classified as fixed income, ILBs are considered a separate asset class from equities and traditional bonds. That’s because their returns don’t correlate with those of stocks or other fixed income assets, making them good picks for diversification and for mitigating volatility.

What happens during periods of deflation?

If ILBs are a hedge against inflation, should you be worried about what happens in the event of deflation? The short answer is yes. A persistent decline in prices during the life of an ILB constitutes one of the pitfalls of that investment tool. If a deflationary trend emerges, the inflation-adjusted principal could fall below its par value. Consequently, the interest payment would be based on the lower deflation-adjusted amount.

That said, some U.S. ILBs offer deflation floors when the bonds mature. These act as a protection from deflation. So an investor would still receive the full par amount at maturity even if deflation drags the principal below par. Still, interest payments are paid on a deflation-adjusted principal. That means those types of ILBs can guarantee that you won’t lose your initial principal in case of deflation and you can even receive a bigger principal during inflationary periods.

Traditional bonds or ILBs? How to decide

The game changer in the choice between traditional bonds and ILBs boils down to what is called the breakeven inflation rate—a market-based measure of expected inflation. The term refers to the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity. The rate indicates how markets price in inflation expectations.

When the actual inflation rate is at the breakeven level, your total returns on an ILB and on a traditional bond would roughly be equal over the life of the bonds. However, if actual inflation exceeded the breakeven level, ILBs would then outperform traditional bonds and mitigate inflationary risks. Conversely, traditional bonds would beat ILBs when actual inflation is lower than market expectations.

But keep in mind that the breakeven inflation rate concept only works if you’re holding the bond to maturity. If you’re planning on holding the bond over a period shorter than the maturity, the breakeven rate won’t provide you with enough information to compare both types of bonds.

If you plan to sell your bonds before maturity, their value would depend on several factors including the prevailing interest rates at the time of sale. You should also consider market price at the end of your time horizon. For example, even when inflation exceeds the breakeven rate over a year or two, traditional bonds would still beat ILBs if they are trading at higher prices.

A quick glance at Canada’s RRBs

While Canada’s RRBs present a hedge against inflation, they have their own limitations. Unlike their U.S. counterparts, RRBs don’t offer deflation floors. That makes their holders susceptible to a capital loss at maturity if deflation persists. Another pitfall lies in their typically long maturities with some RRBs extending over 20 years. The longer the duration to maturity, the more volatile a bond becomes when interest rates fluctuate.

RRBs’ tax structure is another point to consider. Any inflation compensation on the principal and the interest payments are taxed in the year they occur even though the principal is only paid upon maturity. That’s why holding RRBs in a non-registered account might create some taxation headaches. But holding them inside a registered account eliminates those issues.

A final point to remember is not to lose sight of your investment goals when deciding between an RRB and a traditional bond. Similar to ILB vehicles, RRBs constitute suitable investment tools for diversification and portfolio balance. But they’re not designed to fully replace equities or traditional bonds. If you’re concerned about inflation, an RRB might act as a buffer. However, that hedge could come at the expense of more volatility.