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.
What are the advantages of investing in inflation-linked bonds?
Fixed-income assets can be harmed by inflation, which reduces their purchasing power and reduces their real returns over time. Even if the pace of inflation is moderate, this can happen. If you have a portfolio that returns 9% and the inflation rate is 3%, your real returns will be around 6%. Because they increase in value during inflationary periods, inflation-index-linked bonds can help to mitigate inflation risk.
Are inflation-indexed bonds beneficial?
Although RPI has its own set of flaws, there are always going to be problems when depending on any one aggregated gauge of inflation.
The first issue with a single inflation metric is that we all spend money on various things.
Whether assessed by the RPI, CPI, CPIH, or any other single measure of aggregate inflation, none of us will spend our money on the precise basket of items. Some of us will spend in a slightly different way, while others will spend in a completely different way.
If I spend a lot of money on a new automobile every year, automotive price inflation will have a big impact on my personal inflation rate. If you reside in London and don’t own a car, but instead spend a lot of money on overseas vacations, your personal inflation rate will be determined by the rising costs of vacations rather than cars. Personal inflation will be at two different levels, both of which will be different from the RPI.
A variety of factors influence your personal inflation rate, including your age, lifestyle, income, employment status, where you reside, and how many children you have.
We can see that housing is the largest RPI component as an example of why this could not be an appropriate estimate of someone’s personal inflation rate. For retired investors, though, housing is significantly less important. Depreciation and rent are the two major components of the ‘housing’ category, which retirees are unlikely to bother about because they are more likely to own their own home and are less likely to upsize in the future. Despite the fact that transportation is the second largest RPI component, only over half of London households own a car. So, for a retiree in London, roughly 40% of the RPI basket is completely useless.
This means that owning RPI-linked inflation bonds isn’t going to be a good proxy for our hypothetical retiree’s expenditures. They could strike it rich and witness massive property/car market booms in which case they’ll be quids-in, since they’ll benefit from an increase in the value of their inflation-linked bonds without having to pay more for housing/cars. However, during a moment of slowing for the property market, they may see an increase in the expense of vacations, travel, and catering (which I’m presuming retirees spend more on) (a big part of RPI). In that situation, they’ll most likely be out of pocket because their inflation-linked bonds won’t keep up with their spending.
Overall, while the RPI has problems and appears to be on its way out, you’ll never obtain a perfect match for your individual inflation rate whether you use RPI or CPI.
Even if your basket differs significantly from that used in RPI, inflation-linked bonds will always provide some protection against inflation, which may be preferable to no protection at all. However, because investors pay a premium for inflation protection, it’s up to them to judge if the level of inflation protection is likely to be worth it, based on how closely their spending matches the inflation basket of products.
When utilizing a single aggregate measure of inflation, there are a few extra issues to consider.
Changes in product quality, which can improve the worth of items without rising their prices, are not taken into account by inflation measurements.
Technology is an excellent example of this. If the cost of purchasing a computer remains constant from year to year, the RPI may not be affected, even if the new computer is far better than the previous one.
In 2015, for example, I paid around 1,000 for my laptop. As good as it is now, if I spent 1,000 for a new laptop today, it would be faster, thinner, lighter, have a greater resolution, and last longer than ten seconds on a single charge.
When the price of a particular item in the basket of products rises, the inflation rate rises as well. However, as a result of the price increase, consumers may begin to purchase less of it in favor of a less expensive option.
If the cost of my contact lenses continues to rise, I may have to resort to wearing glasses. In that event, RPI will begin to exaggerate the genuine level of inflation that I (and anybody else who switches) will experience.
As a result, the RPI is a poor indicator of inflation, and inflation isn’t a good indicator of our personal inflation rate.
These kinds of arguments against inflation-linked bonds don’t bother me as much as they do others.
We can never expect any single gauge of inflation to exactly match our personal expenditure, and those in retirement who are most vulnerable to inflation are likely to be grateful for any inflation protection. And some very bright people are working hard to ensure that the inflation basket is as representative as feasible.
Inflation protection will never be flawless, but we can’t expect that from a tool that is meant to be used by everyone.
Inflationary bonds are what they sound like.
ILBs (inflation-linked bonds) are securities meant to assist investors protect themselves from inflation. ILBs are mostly issued by sovereign governments, such as the United States and the United Kingdom, and are indexed to inflation, with principal and interest payments rising and falling in lockstep with inflation.
Should I invest in TIPS in the year 2021?
TIPS’ initial principle value fluctuates daily according on the Consumer Price Index (CPI). New issues have sold at premiums as high as 12.4 percent for the 10-year note in auctions since inflation began to rise in July of last year. Premiums for new 10-year TIPS never reached 1% in the five years leading up to 2020, when inflation was low and interest rates were high.
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):
Are inflation-indexed bonds profitable?
Although inflation is normally terrible for the profitability of any fixed-income instrument since it raises interest rates, an inflation-indexed security ensures a genuine return. The most common type of real return securities is a bond or note, but they can also take different forms. Because these securities provide investors with a high level of safety, the coupons linked to them are often lower than those attached to notes with a higher amount of risk. For investors, there is always a risk-reward ratio to consider. On inflation-indexed securities, the periodic coupon is equal to the product of the daily inflation index and the nominal coupon rate. A spike in coupon payments is caused by an increase in inflation expectations, real rates, or both.
Are bonds a good way to protect against inflation?
A 60/40 stock/bond portfolio is a simple investment strategy that can help you buffer against inflation, but keep in mind that it will underperform an all-equity portfolio over time due to compounding interest effects.
Is it ever a good idea to invest in a bond with a negative interest rate?
Negative bond rates may also appeal to investors if the risk of loss is lower than that of other investments. Many investors rush to acquire bonds in times of economic instability because they are considered safe-haven investments. In the bond market, these purchases are known as the “flight to safety” move.
Should I start buying advice right now?
When is the best time to buy TIPS? TIPS, unlike other bonds, adjust payments when interest rates rise, making them a desirable investment choice when inflation is high. This is a decent short-term investment plan, but stocks and other investments may provide superior long-term returns.