Here’s how inflation-linked bonds can help protect your nest egg

Table of contents

• How can ILBs protect your nest egg from inflation?
• What happens during periods of deflation?
• Traditional bonds or ILBs? How to decide

Key takeaways

• Inflation-linked bonds offer a hedge against inflation risk, helping to preserve your purchasing power.
• Inflation-linked bond returns are pegged to the cost of consumer goods. The bond’s principal and interest payments rise as inflation rises.
• Inflation-linked bonds are typically issued by sovereign governments, and each country terms them differently.

Related articles

• How inflation could affect your investments
• An introduction to bonds
• Seven strategies to help manage volatility and risk

While inflation in Canada and in the U.S. has somewhat normalized, and interest rates have come down, inflation can bite fixed-income investors. If, for example, you have fixed income investments yielding 4%, and inflation runs at 2% on average, your real rate of return is 2% (4% minus 2%). If the value of your investment doesn’t keep pace with inflation, you lose future purchasing power.

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

How can ILBs protect your nest egg from inflation?

Returns on inflation-linked 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%. If the inflation rate remains unchanged, the bond will pay you interest of $50 every year.

However, if the CPI rises 2%, 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 – in the U.S., they are called Treasury Inflation-Protected Securities (TIPS).
• Linked to the country’s CPI – in Canada, until 2022, the central bank issued Real Return Bonds (RRBs) and tied 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.

• If the 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.
• If inflation exceeded the breakeven level, ILBs would 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 will 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.