It’s common advice for investors to spread their money around across a variety of markets and securities. The difference between bonds, which are essentially loans to a firm, and stocks is that the latter give the investor a chance to become a part owner of the company. With inflation at its highest in decades, what returns should investors expect from Inflation Adjusted Bonds and are they the best form of inflation protection? Most of you probably already know about Inflation Adjusted Bonds, but just in case you don’t, let’s review it briefly in this article.
Meaning of Inflation Adjusted Bonds
Inflation adjusted bonds, also known as inflation, indexed bonds, are a type of bond that is tied to the costs of consumer goods as measured by an inflation index, such as the consumer price index (CPI). It is a specific kind of bond meant to shield buyers from the consequences of inflation. This kind of bond is a desirable investment if you want to maintain the purchasing power of money over time.
Such bonds are a type of financial security in which the face value of the bond fluctuates in value according to an official price index, rising with inflation and falling with deflation. The coupon rate less the inflation rate equals the real return on the bond.
An inflation adjusted bond’s value is determined by multiplying the bond’s face value by the gearing ratio, which is a constant multiplied by the index’s change since issuance. In most cases, the gearing ratio is near to one.
Benefits of Inflation Adjusted Bonds
Inflation adjusted bonds, also known as inflation, indexed bonds, have several benefits, including:
- Protection from inflation: Inflation adjusted bonds adjust principal and interest payments to account for changes in the inflation rate to shield investors from inflation.
- Increased social welfare: By reducing the effect of inflation on low-income families, inflation-adjusted bonds can increase social welfare.
- Lower debt costs: Because inflation adjusted bonds are less risky than regular bonds, governments can issue them for less money.
- Easier implementation of monetary policy: Implementing monetary policy can be made simpler by inflation adjusted bonds since they give central banks a more accurate representation of real interest rates.
- Enhance creditability: Governments can increase their credibility in the eyes of investors and the public by issuing inflation adjusted bonds by demonstrating their commitment to reducing inflation.
- Diversification: Investor diversification is facilitated by inflation adjusted bonds because their returns do not correspond with those of equities or other fixed-income assets.
Limitations of Inflation Adjusted Bonds
There are certain limitations of these bonds which are as follows:
- Tax payment: Interest is tied to inflation adjusted principal, so it rises with inflation. Inflation adjusted interest income is taxed, although principal may be received at maturity depending on market conditions. Thus, investors may be taxed on income they have yet to receive.
- Interest rate risk: Due to inflation adjusted bonds propensity to vary in value with changes in interest rates, investors who sell their bonds before they mature may suffer losses.
- Less protection during deflation: Bonds that have been adjusted for inflation do not provide as good of protection during deflation.
- Lower yields: As they provide inflation protection, inflation adjusted bonds often have lower yields than ordinary bonds.
- Limited availability: It’s possible that not all countries will have access to inflation adjusted bonds, or that they will be available in less quantity.
Overall, despite these limitations, inflation adjusted bonds can still be a suitable investment option for people and organizations wishing to diversify their portfolios and hedge against inflation.
How does Inflation Adjusted Bonds work?
Inflation adjusted bonds, also known as inflation-linked bonds, are financial securities that protect investors from inflation. They work on below mentioned way:
- They offer fixed interest rates and a regular income over a long period.
- The principal and interest payments on inflation indexed bonds are adjusted for changes in the inflation rate by linking the bond to an index, such as the consumer price index (CPI)
- The CPI is used as a means of the average change in prices reimbursed by consumers for a basket of goods and services.
- It is used to calculate the rate of inflation.
- The principal is regularly adjusted for inflation, and the fixed-interest rate is applied to the adjusted principal.
- Coupons are paid midyear, and the calculated coupon rate reimburses on an adjusted principal.
- Interest on the bonds is paid semi-annually, creating a gradually rising stream of interest payments if inflation continues.
Inflation-indexed bonds are an effective way to hedge against inflation and protect investors from the effects of inflation.
Interest calculation on Inflation Adjusted Bonds
Typically, the principal amount is adjusted to inflation. This implies that if inflation rises, the bond’s principal value will as well. An inflation adjusted bond’s interest payments are calculated using a formula that accounts for the current level of deficit financing.
For example, if the rate of inflation is 3% and the interest rate on the bond is 5%. The interest payment would be computed as 5% of the current principal value + 3% of the original principal value.
Index used for calculation of interest on Inflation Adjusted Bonds in India
The average change in prices that consumers are reimbursed for a selection of goods and services is measured using the Consumer Price Index (CPI). For changes in the consumer price index, the principal and interest payments on inflation-indexed bonds must be modified. It is used to determine the inflation rate.
Tax on Inflation Adjusted Bonds
Inflation Adjusted bonds in India have the same tax treatment as other debt instruments. A 20% long-term capital gains tax with an indexation advantage is applied to the capital gains. Additionally, the interest is taxed at the investor’s individual income tax rate.
Are Inflation Adjusted Bonds same as Inflation Adjusted Bond funds?
The terminology used for inflation-linked bonds and funds may be a little different in India but the idea, is the same. Inflation-adjusted bonds (IIBs) or inflation-linked bonds (ILBs) are the names given to inflation-adjusted bonds in India. These government-issued bonds act as an inflation hedge by altering principal amounts and interest rates in response to changes in the inflation rate.
In contrast, mutual funds, or exchange-traded funds (ETFs) that invest in a portfolio of inflation-linked bonds issued by the Indian government or other companies are referred to as inflation-adjusted bond funds in India. These funds seek to expose investors to a variety of portfolios.
The fundamental idea behind inflation-adjusted bonds and inflation-adjusted bond funds in India is the same. By altering the principal amount and interest payments in response to changes in the inflation rate, they both seek to give investors a hedge against inflation.
Takeaway
Depending on his estimates for inflation, an investor should decide how much to invest in these inflation-adjusted bonds. These bonds are designed in a way that, in the opinion of market experts, is optimal for all investors and institutions.
These bonds’ main objective is to safeguard investors from inflation by making regular and fixed coupon payments. The primary goal of the government’s IAB bonds is to shield gold investors’ portfolios from inflation by focusing on them.
