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Inflation-Linked Bonds (TIPS) – What They Are and How They Work

inflation bonds

Last updated on 12 de March de 2023

Inflation-linked bonds are a great option for investors looking to hedge the risk of future inflation. In this post we analyze what they are, how they work and whether they are the right investment for us.

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What are Inflation-linked Bonds?

Inflation-linked bonds are bonds whose future payments are tied to the level of future inflation. Consequently, they offer us the stability that normal bonds have with the added advantage of protecting the the real value of our savings from inflation.

These bonds are normally issued by governments. This makes sense since governments tend to collect more taxes when inflation rises, making it possible for them to pay higher interest payments to the owners of those inflation-linked bonds.

In the United States, inflation-linked bonds are known as TIPS, short for Treasury Inflation-Protected Securities. However, other countries, including Germany, France, Spain and the United Kingdom also issue inflation-linked bonds.

There are also some corporate bonds linked to inflation. These are issued by companies whose revenues are highly correlated with the overall inflation level in the economy. An example of such companies would be those in the utilities or telecommunications sectors whose prices go up in line with inflation.

There are important differences between normal bonds, also known as nominal bonds, and inflation-linked bonds.

How Nominal Bonds work

Let us first discuss how nominal bonds work with an example: we lend €100,000 to a government or company by buying a bond, and the issuer of this bond agrees to pay us back in 10 years with an annual interest rate of 5%.

In such a scenario, we will receive €5,000 in interest every year and recover the initial €100,000 after those 10 years. The math is extremely simple because we can predict all cash flows with precision.

However, calculations are simple on a nominal basis, not on a real basis. If during these 10 years there has been an average annual inflation of 10%, our money will have lost much purchasing power.

To put that into perspective, the value of €100,000 after 10 years of 10% inflation would have gone down to €38,500. We would have suffered a loss of purchasing power of €61,500, much more than we have received in interest.

And this is always the risk when we invest in nominal bonds: we know how much money we are going to receive. But we have no idea how much that money will be worth in the future.

How Inflation-linked Bonds work

On the other hand, how much money we get from inflation-linked bonds depends on how high inflation is. Let us illustrate that with an example:

We are going to lend €100,000 to a government by buying an inflation-linked bond. The government agrees to pay us an annual interest of 1% in the form of coupon, pay us back in 10 years, and adjust all payment amounts in line with inflation. This works the following way.

Whenever it is time to receive an interest payment and when the bond is due to mature after 10 years, we will look at the value of the official inflation index (CPI in the US, RPI in the UK, and so forth), and adjust the payment due in line with the increase in the index.

If at the end of the first year inflation has been 4%, the nominal value of the bond will increase from €100,000 to €104,000 (4%). And we will receive 1% interest on the new nominal amount of the bond. So, we will receive € 1,040 in interest.

If at the end of the second year inflation has been 3%, the nominal value of the bond will rise by a further 3%. It will go from €104,000 to €107,120. And we will receive an interest payment of 1% on that: €1,071.20.

Let us say that, after the end of those 10 years, prices have risen by an accumulated 48%. The nominal value will have increased to €148,000. Interest in the last year will be €1,480 and we will receive our principal back which will have grown to €148,000.

Obviously, if inflation had been lower than that, we would have received a lot less Euros. However, the key is understanding that these bonds protect the value of our money from inflation.

When we buy inflation-linked bonds, we do not know how much money we are going to get in the future. What we do know is the value of the money that we will receive.

Although getting €148,000 after 10 years, instead of the initial €100,000, sounds very good, remember that prices have also risen by an accumulated 48%. The value of the money we receive 10 years later has not increased. It has merely remained stable.

By the same token, if there had been no inflation, we would have received the same initial €100,000. And that would have been fine, since the value of those Euros would still be the same.

As you can see, inflation-linked bonds have less risk from a purchasing power perspective. And real inflation-adjusted returns are way more important than nominal returns.

How to know if Inflation-linked Bonds are Attractive

Inflation-linked bonds trade very differently than nominal bonds do.

In the case of nominal bonds, we know how much money we will receive in the future. And we also know how much we are paying for the bond. With this information we can calculate the yield of that bond.

This future return is nominal. It tells us how much we will make very year if we hold the bond until it matures.

However, in the case of inflation-linked bonds, we do not know how many Euros or US Dollars we will receive in the future. Fortunately, we do know the value of the money we will receive, since that depends on future inflation.

For this reason, inflation-linked bonds are not quoted based on their nominal yield, but based on their real yield. If the real yield quotes is 1%, we know that our investment will return 1% above the inflation rate.

If inflation averages 4%, the nominal return will be 5%. If inflation is 0%, the nominal return will be 1%. And the final nominal yield is irrelevant. Real returns are what matter most.

Nominal Bonds or Inflation-linked Bonds?

How do we decide if we should invest in nominal bonds or inflation-linked bonds? Before trying to answer this question, remember that, from an investor’s perspective, inflation-linked bonds have less risk because we know in advance what the value of our money will be.

However, we should also decide which type of bonds is more attractive at any given time.

This question is answered by looking at the difference between the nominal yield on nominal bonds and the real yield on inflation-linked bonds. In financial markets, this difference is known as breakeven inflation rate. It is the level of inflation that would make both types of bonds have the same return in the future.

If we believe that inflation is going to be higher than the breakeven rate, it is better to invest in inflation-linked bonds, as they will have a higher return. If we believe that future inflation will be lower than the breakeven rate , it is better to invest in nominal bonds as those would have the better return.

If the nominal bond yield is 5% and the real yield on the inflation-linked bond is 1%, the inflation breakeven rate is 4%. In such a situation, it makes sense to invest in inflation-linked bonds if we expect average annual inflation to be above 4%.

Conversely, if nominal bonds offer a 2% yield and inflation-linked bonds offer 1%, the breakeven is only 1%. If we expect inflation to be higher than 1% we should go for inflation-linked bonds.

As you can see, it is about comparing the breakeven rate with the inflation that we expect in the future. Interestingly, the breakeven rate tells us how much inflation the markets are expecting in the future.

And if the breakeven is low, we have little to lose by betting on inflation-linked bonds.

How to Invest in Inflation-linked Bonds

There are several ways to invest in inflation-linked bonds. The main two are the following:

Exchange-Traded Funds

One of the easiest ways to invest in inflation-linked bonds is by buying an ETF holdings these types of bonds. There are many options available, giving us the option to select which countries and maturities we want to invest in.

For example, Blackrock offers the iShares TIPS Bond ETF, which invests in almost all inflation-linked bonds issued by the US government.

While that may be a great option for US-based investors, those in other countries will also be able to find exchange-traded funds of US TIPS that hedge the currency risk. For investors whose domestic currency is the euro or the pound, the following products would be good options.

Legal & General offer an ETF that invests in German and French inflation-linked bonds. This is another great alternative for Eurozone investors.

Individual Inflation-linked Bonds

Another good option to invest in inflation-linked bonds is to buy some of these bonds directly. This will allow us to choose how much money we want to put into each issue.

Some brokers, including Interactive Brokers, allow investors to pick their own bonds. We can invest in them in increments of $1,000 or €1,000, depending on the currency in which the bonds are denominated.

Risks of Investing in Inflation-linked Bonds

Despite being a very safe investment, there are also risks when it comes to investing in inflation-linked bonds.

The most important risk inflation-linked bonds have is related to interest rates. Although these bonds have a real interest rate, remember that real interest rates can also increase. If that happens, the price of the bond will go down.

This price drop is only an issue if we intend to sell the bond before maturity. If we plan to hold it until it matures, we can disregard this risk.

The other risk we must highlight is that inflation calculations are done by the government. And governments always prefer to report lower inflation figures. This is because a higher inflation rate makes governments look bad and increases the payments they have to make to retirees, public workers, etc.

Hence, the risk is that government understate inflation and our inflation-linked bond does not offer a perfect inflation hedge for us.

This is something that has been discussed for over a decade, both during low inflation and high inflation. There are people doing their own inflation calculation and they always arrive at the conclusion that the official inflation rate is slightly below the real inflation in the economy.

If you want learn more about other risks of investing in bonds, check out this section:
Risks of investing in Fixed Income

Other Investments that Protect us against Inflation

For those who wish to protect the value of their wealth from the negative effects of inflation, it may be wise to combine inflation-linked bonds with other types of assets. At the end of the day, remember that diversification is always a key factor for successful long-term investing.

Some of the best assets to protect us from inflation and currency devaluation are gold, commodities and real estate.

If the inflation rate is moderate, the stock market is a very good option. But stocks can suffer considerably if inflation spirals out of control, as that leads to serious economic problems and higher interest rates.

What happens if there is Deflation?

Some readers may be wondering what happens to inflation-linked bonds in the event of deflation. In other words, if prices go down, does that mean the nominal value of my bond will also go down?

In most cases the answer is no. Most inflation-linked bonds have a 0% floor. That means that, if the official inflation rate is negative, a rate of 0% will be used.

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