Whether the stock market is soaring or the world is on edge due to international conflict, inflation can eat your investments. Fortunately, most nation’s governments sell inflation-linked bonds that grow by mirroring the inflation rate. If inflation causes your investments to suffer or significantly hurts your purchasing power in the market, inflation-linked bonds can strengthen your portfolio. Let’s take a look at how these bonds work and strategies for investing in them.
A financial advisor can help you create a financial plan to protect your investments from inflation and recession.
What Is an Inflation-Linked Bond?
An inflation-linked bond (ILB) is an asset that provides returns based on inflation. In the United States, the federal government sells two types of ILBs: I Bonds and Treasury Inflation-Protected Securities (TIPS). The performance of these assets correlates with the inflation rate according to the Consumer Price Index.
The governments of countries across the globe sell ILBs. In times of rampant inflation, ILBs can outperform other securities. Additionally, they can help investors maintain more liquidity when inflation devalues other assets.
How Does Inflation Impact Your Investments and Portfolio?
Inflation can inflict subtle yet substantial damage to your portfolio, even when your investments seem to perform well. For example, let’s say your investments have a 10% nominal rate of return at the end of the year. While 10% is encouraging on the surface, you need to figure in the inflation rate to get a better idea of the real rate of return. An inflation rate of 6% would mean that your portfolio had a 4% real rate of return.
Understanding Inflation-Linked Bonds
The two ILBs from the U.S. government operate differently to give investors returns based on inflation: I Bonds and Treasury Inflation-Protected Securities (TIPS). Here is a breakdown on how each works:
I Bonds
I Bonds build interest based on the inflation rate, which the Consumer Price Index calculates. One advantage that U.S.-issued ILBs offer is guaranteed value: your investment’s value will never drop beneath what you paid. This guarantee makes I Bonds an attractive option for conservative investors and investors who want to hedge against inflation but also have concerns about the inflation rate dropping. In short, I Bonds can give you robust returns when inflation rises, but their value won’t dip beneath the purchase price if inflation cools off.
You can’t invest in an I Bond fund or place I Bonds in an IRA – you can only purchase the bonds themselves. Additionally, regulations limit I Bond purchases to $10,000 per year plus $5,000 more to purchase with tax refunds.
I Bonds fully mature at 30 years, but you can redeem them after as little as one year of holding them. If you sell or redeem an I Bond before holding it for at least five years, you will loose income equal to three months of interest. In addition, you must sell or redeem your I Bonds to make a profit, unlike other ILBs that provide investors with steady interest payments. Therefore, I Bonds don’t give investors as much liquidity, and investors looking for accessible income during bouts of inflation may consider TIPS a better option. However, the advantage is that you only pay income tax when you redeem the bonds.
Treasury Inflation-Protected Securities (TIPS)
Treasury Inflation-Protected Securities (TIPS) is the other ILB the U.S. federal government sells. While I Bonds’ value comes from the interest that matches the inflation rate, TIPS’ principal and interest both adjust according to inflation. You can purchase TIPS from the federal government or through your broker. In addition, you can invest in mutual funds and exchange-traded funds solely committed to TIPS.
The purchase limits for TIPS are not stringent enough to pose trouble to most investors. As such, investors with a broad range of wealth and financial situations can use them to mitigate inflation’s effects on their portfolios and income. Moreover, because TIPS accrue interest semiannually (twice per year), they can act as an effective income stream. Additionally, you can sell TIPS investments to other investors at any time, allowing you to capitalize on your gains quickly. However, it’s crucial to note that unless your TIPS are in an IRA or 401(k), you will have to pay taxes on the income you earn from them each year.
History of Inflation-Linked Bonds
Inflation-linked bonds go back to the American Revolutionary War, when Massachusetts issued them to address extreme inflation caused by the conflict. Though the bonds were effective against inflation during the war, Americans stopped using them after inflation declined.
Other than the Revolutionary War exception, every nation, including the United States, did not issue inflation-linked bonds until the modern age. In the 1970s, most countries no longer used the gold standard to back their currencies, and inflation began taking off. The U.K. was the first country to sell inflation-linked bonds when it created what were known as “linkers” in 1981. Countries gradually got on board with the idea, and the U.S. began selling inflation-linked bonds in 1997.
Risks of Investing in Inflation-Linked Bonds
Inflation-linked bonds can help you build a defense in economically turbulent times, but they have flaws as well. Interest rates often influence an ILB’s value, and the gains that ILBs make can vanish because of deflation. While the United States federal government guarantees that their ILBs’ value will never drop beneath their purchase price, investors lose out comparatively on other investments when their ILB provides a return between zero and two percent.
Additionally, TIPS can be challenging to trade and fully take advantage of when profitable adjustments occur. Investors receive annual interest payments (known as the coupon) based on the adjustments, but the bonds must mature or be sold for the investor to receive income from the principal. However, investors must pay taxes each year on favorable annual TIPS adjustments, meaning they can owe taxes for income they haven’t received.
Bottom Line
Inflation-linked bonds can be a solid investment during challenging economic times. Because their returns directly correlate with the inflation rate, investors can retain their purchasing power through ILBs. However, I Bonds are not the most liquid of investments, and most investors will have the incentive to hold onto them for five years or more before selling them. Conversely, TIPS are more liquid and have higher return potential than I Bonds, but inexperienced investors may have difficulty realizing the returns before deflation reduces them.
Tips for Smart Investing
- A financial advisor can help you understand how to invest in inflation-linked bonds and other securities during challenging economic times. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Diversifying is crucial for a healthy portfolio, but it can be tough to distinguish how much to allocate toward Treasury Inflation-Protected Securities and other assets. SmartAsset’s asset allocation calculator can help you understand how risk tolerance influences your investing decisions.
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