Government-issued inflation-linked bonds (ILBs) are fixed-income securities whose principal value is changed monthly according to the rate of inflation; ILBs lose value when real interest rates rise.
Is it a good time to buy inflation-linked bonds?
I Bonds are financial instruments that have very specific regulations, attributes, and predicted yields and returns. Understanding these should assist investors in making better investing decisions, so I though a quick, more mathematical explanation might be helpful.
Current inflation rates, which are equivalent to 7.12 percent, forecast inflation rates, and the length of the holding term can all be used to estimate expected returns on I Bonds. Let’s begin with a simple example.
I Bonds are presently yielding 7.12%. Because interest is paid semi-annually, if you buy an I Bond today, you will receive 3.56 percent interest in six months. The following is the scenario:
If inflation stays at 7.12% throughout the year, these bonds should keep their 7.12% yield and you should get another 3.56 percent interest rate payment in the second half of the year. When you add the two interest rate payments together, you receive 7.12 percent for the entire year, which is exactly what you’d expect. The following is the scenario:
If you cash out the bond after three months, you will be charged a 1.78 percent interest rate penalty. When I subtract the penalty from the above-mentioned interest, I get a year-end estimated return of 5.34 percent.
The inflation rate for the second half of the year is the sole real variable in the above equation. For the first half, inflation and interest rates have already been set at 7.12 percent and 3.56 percent, respectively. The penalty is determined by the interest rate paid in the second half of the year, which is, in turn, determined by inflation. As a result, we can condense all of the preceding tables and calculations into the following simple table.
The technique can likewise be extended to various forward inflation rates. The following are the details.
Returns are higher when inflation is higher, as can be seen in the graph above. If inflation is low, returns are still reasonable because investors can lock in a 3.56 percent interest rate payment if they buy now, regardless of how inflation evolves. Investors would receive 4.06 percent in interest payments in 2022 if inflation falls to 2.0 percent, which is the Federal Reserve’s long-term goal.
If forecast inflation rates remain constant throughout time, the table above can be extended to span different holding periods. Although this is not a realistic assumption given the volatility of inflation rates, I believe the study will be useful to readers. The following are the more detailed results.
When inflation is low, the best gains come from buying bonds, receiving the guaranteed 3.56 percent interest rate, and selling them quickly. If inflation falls, there’s no benefit in owning an inflation-protected bond.
When inflation is high, the best profits come from keeping bonds for a long time, allowing you to receive as many (high) interest rate payments as possible while minimizing or eliminating the penalty for holding for a short time. When inflation is strong, there’s little value in selling an inflation-protected bond.
Importantly, investors have the option of deciding how long they want to hold these bonds, thus the most rational course of action is obvious: hold the bonds until inflation falls, then sell. This, of course, is quite reasonable. When inflation is high, inflation-protected securities are profitable; when inflation is low, they are not. As a result, when inflation is high, as it is now, it makes sense to acquire inflation-protected securities and then sell when inflation falls. It’s a common-sense approach, and the math adds up.
How do inflation-linked bonds get their value?
Divide the Reference CPI for the settlement date by the Reference CPI for the issue date to get the Index Ratio. This computation is based on the assumption that the Index Ratio will be greater than one on the bond redemption date.
When inflation strikes, what happens to bonds?
The purchasing power of a bond’s future cash flows is eroded by inflation. Simply said, the higher the current rate of inflation and the higher the (anticipated) future rates of inflation, the higher the yields throughout the yield curve will climb, as investors would demand a larger yield to compensate for the risk of inflation.
Will bond prices rise in 2022?
In 2022, interest rates may rise, and a bond ladder is one option for investors to mitigate the risk. Existing bond prices tend to fall as interest rates (or yields) rise, as new bond yields appear more appealing in contrast.
Is it wise to invest in I bonds in 2022?
- If you bought bonds in 2021 and wanted to buy more but hit the annual limit, now is a good time to acquire I bonds.
- If you want to “get the greatest deal,” you should keep an eye on the CPI-U inflation indicator.
- The difference between the March figure (released in April) and the September number of 274.310 determines the following I bond rate. The February number is 283.716 as of March 10, 2022. If there is no further inflation, the rate will be 6.86 percent from May to November 2022.
- You may wish to buy your next I bonds in April or wait until May, depending on the CPI number announced in April.
- However, there’s a strong chance you’d rather buy I bonds by April 28, 2022 or earlier to take advantage of the 7.12 percent rate on new purchases through April 2022.
An I bond is a U.S. Government Savings Bond with a fixed interest rate plus an inflation adjuster, resulting in a real rate of return that is inflation-adjusted. The I bond is an excellent place to seek for savers in a world where inflation is a concern and there are few inflation-adjusted assets.
- If you cash out between the end of year one and the end of year five, you will be penalized by losing the previous three months’ interest.
- You can only purchase $10,000 per year per individual, and you must do it through TreasuryDirect.gov.
Read on for additional information on I Bonds and why April might be a good time to buy them.
Many of the investors we speak with had never heard of US Series I Savings Bonds (I Bonds), but were recently made aware of them due to the eye-popping yields they began giving in 2021.
When the 6-month ‘inflation rate’ of 1.77 percent was published in May 2021 (which is 3.54 percent annually! ), coverage began in earnest.
I Bonds: The Safe High Return Trade Hiding in Plain Sight & Investors Flock to ‘I Savings Bonds’ for Inflation Protection WSJ: I Bonds the Safe High Return Trade Hiding in Plain Sight & Investors Flock to ‘I Savings Bonds’ for Inflation Protection
You’ll be earning twice as much for half of the year when the US government reveals the 6-month inflation rate. The I bonds are priced in semi-annual 6-month terms, although most interest rates are quoted in annual terms. Simply double the 6-month inflation rate to determine the annualized rate and compare it to other rates.
Your $100 investment in April 2021 I bonds will be worth $103.56 in about 6 months. This equates to a 7.12% annualized rate.
You’ll get a new six-month rate after six months, and your money will increase at that pace.
You must hold I bonds for a period of 12 months, and you have no idea what the next 6 months will bring in terms of interest, but what could go wrong?
In the worst-case scenario, you earn 7.12 percent interest for the first six months after purchasing your I bond, then 0 percent thereafter. 6 months later, your $100 would be worth $103.56, and 12 months later, it would still be worth $103.56. If the rate in a year’s time isn’t what you want, you can cash out your I bond in a year’s time, forfeit the three months’ interest (which would be 0% or more), and still have $103.56. (or more).
Since the inception of I bonds in September 1998, there have been 48 declared inflation rate changes, with only two being negative!
Even if inflation is negative, the interest rate on I bonds will never go below 0.0 percent!
Consider how much you can commit to a 12-month interest rate that pays more than 3.5 percent when you open your bank statement and require a microscope to discover the pennies of interest you’re getting. I bonds are dubbed “America’s Best Kept Investing Secret” by Zvi Bodie. Let’s battle the current low interest rates by purchasing some I Bonds and informing everyone we know about this fantastic offer. Go to TreasuryDirect.gov to purchase your I Bonds.
- Jeremy Keil writes, “October 2021 Will Probably Be the Best Month Ever in History to Buy I Bonds.”
In South Africa, how do inflation-linked bonds work?
The markets are concerned about inflation as global printing presses work overtime, bond rates rise, key yield curves steepen, and food, energy, and commodity prices all rise. It’s likely that you are as well.
Given that inflation is best defined as a rise in the price of goods and services, and since businesses offer things and services, equities are frequently a solid long-term inflation hedge. While this cannot be overstated, many investors are currently overweight in stocks, and adding to this overweight position may not be the best decision.
Similarly, some investors, particularly those who are late in life or have a low risk tolerance, seek’safer’ and/or income-yielding investments, which equities normally do not provide.
While regular fixed-coupon bonds are eaten for breakfast as inflation rises, there is a special type of bond that tracks inflation: inflation-linked bonds (ILBs), also known as Treasury inflation-protected securities (TIPS) in the United States.
As a result, as the value of the capital increases due to inflation, the fixed interest rate paid on it increases by the same amount. As a result, the bondholder is safeguarded against inflation in theory. In practice, however, their performance is determined by actual yield movements, which have risen in South Africa as the country’s credit rating has been reduced, causing many ILBs to underperform inflation recently.
There are other dangers as well, not the least of which is credit risk. There’s also the question of how inflation is computed (there are numerous claims that the CPI understates our country’s true inflationary pressures).
You can buy individual ILBs in the market or invest in RSA Retail Bonds via an exchange-traded fund (ETF) or an exchange-traded note (ETN).
Various ETF providers, the RSA Retail Bonds website, and the author’s own estimates were used as sources.
* TIC = Total investment cost (Satrix only discloses the total expense ratio (TER) for its ILB ETF, which we used in place of the TIC above).
*** A request for redemption beyond the first year is subject to a penalty fee.
What is obvious from the preceding is that any allocation into this space is fraught with compromises:
- While the Satrix ILB ETF is less expensive than other ETFs with higher gross yields, it looks to have a higher bidding spread (i.e. entry-cost).
- The Ashburton Inflation ETF is the largest and most liquid of the ETFs, despite its dismal performance on most metrics.
- Finally, while an inflation-linked RSA Retail Bond may not give the best yield or liquidity, it does provide the investor with a bond that is free of indirect expenses (i.e. it is the ‘cheapest’).
If you want to make a substantial, one-time investment in this market, Satrix’s ILB ETF is probably the best option because the spread is only paid once (or not at all if you go directly via Satrix).
Alternatively, if you do not require the money you are investing (i.e., you can afford to accept liquidity risk), look at the RSA Retail inflation-linked bonds and extend their duration to the maximum; both the five-year and 10-year gross yields outperform the ETF possibilities.
While ILBs have underperformed as our country’s credit risk has increased, dismissing them as an asset class would be hasty, as they still provide an attractive option for individuals seeking stability, safety, and income with some inflation protection.
Listen to Ryk van Niekerk’s interview with Marriott Investment Managers’ CIO Duggan Matthews (or read the transcript here):
What are index-linked bonds and how do they work?
The payment of interest income on the principal of an index-linked bond is connected to a certain price index, usually the Consumer Price Index (CPI). Investors are protected by this provision, which shields them from changes in the underlying index. The cash flows of the bond are modified so that the bond holder receives a known real rate of return. In Canada, an index-linked bond is known as a real return bond, in the United States as Treasury Inflation-Protected Securities (TIPS), and in the United Kingdom as a linker.
What is the 5 year TIPS yield?
The difference between the 5 year Treasury rate and the 5 year Treasury inflation-indexed security rate is used to compute the 5 Year TIPS/Treasury Breakeven Rate. This figure is used by market participants to estimate what inflation will be in the next 5 years on average. The breakeven rate was as low as -2.24 percent during the Great Recession.
The 5 Year TIPS/Treasury Breakeven Rate is 3.34 percent, down from 3.41 percent the day before and 2.54 percent the year before. This is greater than the 1.87 percent long-term average.
How can I keep my investments safe from UK inflation?
Talib Sheikh, Multi-Head Asset’s of Strategy, explains why high inflation is harmful for investors and what they can do to protect their money’s purchasing power.
Inflation in the United Kingdom is at historic highs, and the Bank of England expects it to rise even more this spring. According to the most recent numbers, prices rose by 5.4 percent from December 2020 to December 2021, the highest increase in at least 30 years. This is exacerbated by record low interest rates, making the situation even more difficult for savers. Savings rates were frequently higher than inflation in the 1980s and 1990s, therefore cash savers made money in real terms. With interest rates sitting just near zero, savers are losing almost the whole inflation rate. To find something similar, you’ll have to travel back nearly 50 years. At current levels, even “safe” lower-risk investments like investment grade credit and government bonds are diminishing investors’ real spending power.
The real question is how long this will go on. ‘Transitory’, short-term bottlenecks connected with re-opening have received a lot of attention. Because we were in a post-pandemic phase of very low inflation this time last year, inflation appears to be high. It began to rise in spring 2021, thus the data will start to look less scary starting this spring.
Inflation in the United Kingdom, on the other hand, is expected to remain structurally higher than in the post-GFC period. The epidemic appears to have had long-term consequences on employment, bringing retirement and lifestyle changes forward, in addition to the loss of EU nationals following Brexit, which has resulted in higher salaries. For the foreseeable future, the Brexit transition will impose frictional costs on UK businesses. Furthermore, fiscal spending is expected to continue high: austerity in the aftermath of the 2008 financial crisis is no longer fashionable.
These factors contribute to the market’s forecast of a stunning 4% inflation rate for the UK over the next ten years. What about the savings rates on the other side of the equation? The ten-year interest rate in the United Kingdom has risen, although it is still only 1.5 percent. Andrew Bailey mentions raising interest rates to combat inflation, but he can only go so far. Over the last 10 years, UK homeowners have failed to lower debt levels, implying that the housing market remains a significant element of the UK economy. As a result, the UK is unable to accept interest rates that are significantly higher.
As a result, the problem of inflation eroding cash savings and low-risk investments isn’t going away anytime soon. At 4% inflation, a 100,000 cash investment earning 1% interest (which already assumes two more Bank of England rate hikes) loses a fifth of its real value in just ten years.
Investing is one strategy for people to protect themselves against inflation. While traditional assets such as high-quality credit offer low returns, equities, high-yield debt, emerging markets, and alternatives can provide significantly higher returns while also exposing investors to greater risk.
Investors in the United Kingdom who do nothing risk seeing their rainy-day accounts, retirement savings, and vacation funds decimated at the fastest rate in history by inflation. There are, however, other options for investors who want to be protected from inflation. When it comes to achieving the highest potential returns, investing in a multi-asset fund provides flexibility and a broader toolkit. This is accomplished by investing in higher-yielding, higher-risk asset classes while using diversification and active management to manage risk. As a result, even if the threat of inflation has never been higher, it is still conceivable to expand and protect capital in real terms, but it will require a different approach than in the past.