Inflation-indexed bonds - Bonds that go one up on inflation

Budget 2013 had an interesting announcement for investors – launch of an investment that would help them go one up on inflation. Inflation-indexed bonds offer an ideal solution in times of high inflation, a problem plaguing the Indian economy for some time now.

So what are inflation-indexed bonds?

Also known as linkers, inflation-linked bonds are typically high in credit quality, often sovereign, that provide income and total return, which adjusts to keep up with inflation.

Inflation-linked bonds have come a long way since the time they were first launched in 1981 by the UK government. Globally, the market for the bonds has nearly doubled since 2003.

It is observed that the bonds usually perform on expected lines over the long-term – rise in inflation is matched with a rise in returns and vice versa. Being a relatively recent innovation, it remains to be seen how the bonds perform during specific economic crises marked by high inflation or hyperinflation.

Factors that influence performance of the bonds

For all practical purposes, inflation-linked bonds are influenced by the same factors as regular bonds. And they are also traded on the secondary market like other debt securities. So yields on the bonds are influenced by factors like supply and demand of the bonds, fiscal and monetary policy of the union government and economic environment among other variables.

Benefits of inflation-linked bonds

As is evident by now, when inflation is at stubbornly high levels it erodes the gains of fixed return bonds. In such times, investors would like an option with returns that go lockstep with inflation. This is where inflation-indexed bonds come in.

Since returns are adjusted to inflation, yields on such bonds are relatively stable. This means lower price volatility, a trait that is sometimes lacking in other inflation-hedging securities like commodities, for instance.

Also being sovereign in nature means that the bonds have the best credit rating in the country.

How the bonds work

While the calculations behind certain inflation-linked bonds can be complicated, it can be understood easily for certain bonds.

Take an inflation-index bond - ABC Bond with face value of INR 100 and an annual coupon of 5%. The annual coupon payout would be INR 5.

If the inflation index increases by 10%, the principal of the bond would increase to INR 110. The coupon rate would remain at 5%, resulting in an interest payment of INR 110 x 5% = INR 5.5.

Likewise, if inflation had to fall, the original principal of INR 100 would be revised downwards taking the coupon below INR 5.

Clearly, inflation-indexed bonds are useful for investors and merit a place in the portfolio for their ability to counter inflation.  Investors, based on their risk profile and investment objectives and in consultation with their financial planners, can consider investing in them.