Inflation always impacts the performance of your investments. Skyrocketing inflation is giving Indians an object lesson on this fact of investing life, with the most recent consumer price index (CPI) reading up 7.41% in Sept. 2022.
For investors, “real returns” are how much you earn from an investment after taking inflation into account.
Inflation-indexed bonds—also called inflation-linked bonds—offer one way to mitigate rising prices, since the returns of these fixed-income securities are adjusted to account for inflation.
What Are Inflation-Indexed Bonds?
With conventional bonds, investors get a fixed interest rate and receive regular interest payments, also known as coupon payments. The latter are in nominal rupees, meaning an amount that is not adjusted for inflation. The bond’s principal is returned once it reaches maturity.
The inflation risk for conventional bonds is significant, since rising inflation can erode the bond’s value over time.
Let’s say in January you purchase INR 10,000 in one-year bonds. They pay a 1.5% fixed rate per annum, and you get back your principal at maturity. At the end of the year, you will get INR 10,150, but the real value of that return depends on annual inflation.
Inflation-indexed bonds pay a fixed interest rate, offer regular coupon payments and return the principal at maturity. Here’s where they’re different: The principal is regularly adjusted for inflation, and the fixed-interest rate is applied to the adjusted principal.
How Do Inflation-Indexed Bonds Work?
Inflation-indexed bonds reference a market index that measures inflation, like CPI. As the index rises and falls with inflation, the value of the bond’s principal is adjusted, changing the amount you earn with each coupon payment.
Inflation-indexed bonds will provide inflation protection to both principal and interest payments.
Pros of Inflation-Indexed Bonds
- Fixed long-term yield. Inflation-indexed bonds offer a fixed, long-term yield. This is appealing to investors who want the stability of a fixed-income investment but are worried about the impact of inflation.
- Zero inflation risk. They have no inflation risk, meaning your investment is protected against rising prices. This is in contrast to conventional bonds, which can lose value in real terms if inflation rates rise.
- Returns are not linked to the market. The return on inflation-indexed bonds has no correlation to the returns of the stock market, so they can provide a hedge against inflation and provide valuable diversification.
Cons of Inflation-Indexed Bonds
- Less earning potential than other securities. Inflation-indexed bonds have less earning potential than other securities, such as stocks. That’s because they offer a fixed return, while other securities offer the potential for higher returns. In addition, if inflation rates are low, you may not earn as much on your investment as you would on a different security.
- Not a perfect measure of inflation. CPI is the most common measure of inflation for India inflation-indexed bonds. However, it’s hardly a perfect metric. Some experts warn there’s some uncertainty regarding how well inflation-indexed bonds will protect your investment from price rises.
- Phantom income. The phantom income is defined as unrealized gains on investments that are not subject to current taxes. In other words, it’s money you have earned but haven’t actually received yet. With inflation-indexed bonds, phantom income can occur when the CPI rises and the value of your bond increases.
How to Invest in Inflation-Indexed Bonds
These are the most common ways to purchase inflation-indexed bonds in India.
Inflation Indexed National Saving Securities – Cumulative (IINSS-C)
IINSS-C the best-known inflation-indexed bonds in India. Unlike other securities sold by the Government of India, the principal value of IINSS-C can change over its term, adjusted based on CPI.
When the IINSS-C matures and the principal is higher than the original amount, you get a higher amount. If the IINSS-C is equal to or lower than the initial amount, you will get the original amount.
IINSS-C pays a fixed rate of 1.5% per annum and second, inflation rate. For example, if inflation rate during the six months is 6%, then interest rate for these six months would be 7.5% (i.e. fixed rate -1.5% and inflation rate -6%).
Index Funds and ETFs
To invest in inflation-indexed bonds without purchasing individual securities, you can invest in an index fund or an exchange-traded fund (ETF).
Read More: The Best ETFs to Beat Inflation
Index funds offer the benefit of diversification and professional management, allowing you to invest in hundreds of bonds with each share you purchase.
Should You Invest In Inflation-Indexed Bonds?
Inflation-indexed bonds offer stability and protection against inflation for investors. However, there are some drawbacks to investing in these securities, such as less earning potential than other options and uncertainty around the accuracy of the inflation rate measure used.
Inflation-indexed bonds may have a place in your portfolio, but it’s a good idea to meet with a financial advisor to discuss your goals and investment strategy to make sure you’re on the right track.
