Inflation-linked Bonds: Protect Your Investments from Inflation

What are inflation-linked bonds?

Inflation-linked bonds (ILBs) are among the few investments that directly protect investors against the erosive impact of inflation on investment returns. Other investments such as vanilla (or more formally known as nominal) bonds and equities provide no guarantee that they will deliver returns that are in line with, or higher than, inflation.

Inflation’s erosive impact on wealth creation cannot be underestimated. For instance, a R100 monthly income distribution in South Africa, with inflation pegged at the 4.5% midpoint of the inflation target band, would decline in value to R95.50 in real terms after a year, and to R63.10 after 10 years.

The performance of these bonds is safeguarded against inflation as their payment profile and capital values are directly linked to the inflation rate. As a result, their value increases with rising inflation and decreases when inflation falls. ILBs are 'indexed', which means that the principle and interest payments rise and fall in tandem with inflation. This shows that if an ILB is kept to maturity, it will provide a guaranteed return over inflation.

Sovereign issued Inflation-linked bonds are also deemed less risky than corporate bonds from a counterparty exposure perspective because the government issues them. Thus, the capital and income distributions are backed by a government guarantee that investors will be repaid. An investor will not get their money back if the government defaults on its debt, which is a remote risk for local currency denominated bonds.

Where do Inflation-Linked Bonds come from?

The Commonwealth of Massachusetts issued the first ILBs in 1780, during the American Revolution. The United Kingdom was the first developed nation to issue ILBs in the 1980s, followed by Australia, Canada, Mexico, and Sweden. In January 1997, the United States launched its first Treasury Inflation-Protected Securities (TIPS), which are now the largest component of the worldwide ILB market.

The South African government issued the first ILB in March 2000. The R189 was a 13-year bond with a real coupon rate of 6.25%.

How do inflation-linked bonds work?

Inflation-linked bonds, or inflation linkers, ensure that both the capital invested, and the coupons paid are indexed to a specific inflation measure. In South Africa, for example, sovereign issued inflation-linked bonds are tied to the headline consumer price inflation index. The Futuregrowth Core Inflation-linked Bond Fund, benchmarked against the FTSE/JSE IGOV Index, protects investors' capital and income from domestic headline inflation risk. In the US, similar bonds might be linked to the Consumer Price Index for All Urban Consumers, and in Europe to the Harmonised Index of Consumer Prices.

 These composite measures of consumer inflation are deemed most reflective of the rising level of prices in an economy on an annual basis and thus enable the issuers of the debt to protect the purchasing power of the investor.

Comparing Inflation-Linked and (Vanilla) Nominal Bonds

Nominal bonds have no built-in inflation protection. They are called nominal bonds because their value is based on the asset’s current price and doesn’t increase on a relative basis over time, as inflation-linked bond pricing does.

What are the investment benefits of inflation-linked bonds?

• Real return preservation: As mentioned above, when held to maturity inflation-linked bonds provide real (after-inflation) returns. That means that over time, investors are hedged (protected) against inflation and the value of their capital (money initially invested in the bond) and income (the biannual yield distributed by the borrower) doesn’t get eroded by the rising cost of living over time.

• Relatively low-risk investment: Inflation-linked bonds, particularly if issued by the government, are relatively low-risk investments. Unless the government or company issuing the bond defaults, you will receive the income and capital back if you remain invested until the bond matures.

• Diversification: Inflation-linked bonds have distinct diversification benefits in a portfolio because of their ability to hedge against inflation. Other assets like equities and nominal bonds do not offer built-in protection against inflation. Thus, when inflation rises significantly beyond market expectations, inflation-linked bonds tend to outperform their nominal bond counterparts.

How have ILB's Performed in High Inflation Environments?

The FTSE/JSE IGOV, a composite Inflation-linked Bond Index delivered a 6.20% annualised return between end-January 2019 and end-January 2024, which exceeds the average annual headline consumer price inflation rate of 4.96% over the period. Meanwhile, the Futuregrowth Core Inflation-linked Bond Fund has outperformed the FTSE/JSE IGOV Index (its benchmark) over all periods since inception, highlighting its consistent ability to outperform its targeted return. 

Conclusion: Bottom line

Inflation-linked bonds have an essential role to play in an investment portfolio or as a standalone investment because of the protection they provide against the erosive impact of inflation on investors’ wealth. Although inflation has moderated in the past year, the inflation outlook bears upside risk due to the still unpredictable macroeconomic and geopolitical conditions. Thus, inflation-linked bonds offer appeal as an investment vehicle that protects against the erosive effects of inflation on investment returns.