What are inflation-linked bonds and how do they work?

Before reading more about inflation-linked bonds, it is helpful to understand what bonds are and how they work.

Suppose you buy a bond for €100 with a fixed coupon rate of 2% per year and a maturity of 5 years. You will then receive €2 in coupon interest annually. Depending on the current interest rates on similar bonds, this bond can also increase or decrease in value. For example, when interest rates fall, your bond becomes more attractive because it yields more interest than new bonds, making your bond worth more.

This increase in value applies relative to the purchase price, also called the face value. Whether your bond actually increases in value depends on inflation.

What is inflation?

Inflation means you can buy less for the same money, or money devaluation. This happens when products or services become more expensive. An example:

Suppose you earn €3,000 per month in 2021 and spend €2,500 of that on living expenses. In 2022, you continue to earn the same and spend the same amount, but prices increase by 2% (2% inflation). You will then pay €2,550 for the same expenses. So your money has become worth 2% less.

Impact of inflation on bonds

If inflation occurs, your bond becomes worth relatively less. If you receive €2 annually in coupon interest and the bond is redeemed after 5 years for €100, your yield in euros is €10. But the real yield, taking inflation into account, is less.

Inflation-linked bonds

Inflation-linked bonds are designed to address this problem. With these bonds, the principal and/or coupon rate increases with inflation, protecting you from inflation. This can be done in two ways:

  • The coupon rate rises with inflation. If you bought a bond with a coupon rate of €2 a year and there is 2% inflation, the coupon rate will increase by €0.04 that year.
  • The principal increases with inflation. If you bought a €100 bond with a maturity of 5 years and there was 2% annual inflation, you will get €110.41 back after 5 years, preserving your purchasing power.

Note that most inflation-linked bonds take inflation into account in both principal and coupon rates, but not all do.

Disadvantages of inflation-linked bonds

Why aren't all bonds protected against inflation? The reason is cost. As an investor, you pay for that protection. If expected inflation is 1.5% per year, then you will also get 1.5% less coupon interest with an inflation-linked bond than with a comparable bond without inflation protection.

In the Netherlands, the average inflation rate over the past 10 years has been about 2% per year. You can then expect a Dutch inflation-linked bond to yield about 2% less coupon interest than a "normal" bond. So such an inflation-linked bond is only advantageous when inflation exceeds 2%.

Is it wise to buy inflation-linked bonds?

We cannot easily say this. Such bonds are beneficial only when inflation is higher than expected. The expected inflation is already included in the price and interest rate, and that is what you as an investor pay for. So it may be unwise to buy such bonds at a time when inflation has already risen significantly. A good reason to add inflation-linked bonds to your portfolio can be to diversify.

Distribution

Inflation-linked bonds are a different type of investment than "normal" bonds because they react differently to the same situation. By investing in different types of bonds, you create more diversification. This is useful because it reduces your risk. For example, our model portfolios invest in both 'normal' bonds and inflation-linked bonds, so you automatically diversify your (bond) investments.