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Weighing up inflation linked bonds

by , 04 August 2015

Many investors like to include bonds in their portfolios. Whilst the returns are likely to be paltry in comparison to shares, they are safer investments paying you a fixed income.

If you've looked at government bonds, you'll likely have come across inflation linked bonds.

So what are these? And should you invest in them?

Read on to find out…

What are inflation linked bonds?

Inflation linked bonds are bonds whose interest payments relate to the current rate of inflation.

Let’s take a look at an example to see how they work…

Say you have a ten year bond, Cris Sholto Heaton in Money Week explains.

Its interest rate payments or coupon is 2.5%. The bond issuer pays this out annually. The issuer pays the principal (the value of the bond at issue) when the bond matures at ten years. The principal value is R1,000.

By year five, assume cumulative inflation amounts to 25% and 50% by year ten, when the bond matures.

This means the interest payments will rise in line with inflation:

  • The first coupon payment would be R25 (R1,000 x 2.5%).
  • At the end of year five, the coupon payment will be R31.25 (R1,000 x 150% x 2.5%).
  • At maturity, you’d receive a principal payment of R1,500 (R1,000 x 150%).

You’ll find the majority of inflation linked bonds are government issued. The most popular are US Treasury inflation-protected securities (TIPS) and UK index-linked gilts.

Should you invest in inflation linked bonds?

If you’re considering investing in inflation linked bonds, you need to weigh up their yields against those of conventional bonds.

If inflation looks likely to rise above a certain level, inflation linked bonds are worth investing in. This is because, over the long-term, you’ll lose less money.

If you hold bonds as part of your portfolio, it’s certainly worthwhile holding some inflation linked bonds as part of it. This way you can hedge against inflation.

So there you have it. Weighing up inflation linked bonds.

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Weighing up inflation linked bonds
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