Inflation can have a dampening effect on fixed-income investments, reducing their purchasing power and cutting deeply into the real value of returns over time. This happens even if the inflation rate is relatively low. For example, if you have a portfolio that returns 9%, but the inflation rate is 3%, the true value of your returns has been cut by about a third. Inflation-linked bonds (ILBs), however, can help to offset (or hedge) that risk because they increase in value during inflationary periods.

The United States, Canada, Japan and a wide range of European and Asian countries all issue inflation-linked bonds. Because they help to hedge against an uncertain future, ILBs have become a popular long-range planning investment vehicle for individuals and institutions alike. 

How Inflation-Linked Bonds Work

ILBs are still tied to the cost of consumer goods, such as the consumer price index (CPI).

Each country has its own method for calculating those cost on a regular basis. In addition, each nation has its own agency responsible for issuing inflation-linked bonds. In the United States, Treasury inflation-protected securities (TIPS) and inflation-indexed savings bonds (I-Bonds) are tied to the value of the United States' CPI and sold by the U.S. Treasury. In Great Britain, inflation-linked gilts are issued by the U.K. Debt Management Office and link to that country's retail price index (RPI). The Bank of Canada issues that nation's real return bonds, which are tied to the Canada All-Items CPI inflation index, while the Japanese Ministry of Finance's inflation-linked bonds are tied to the Japanese CPI.

In general, for ILBs issued in every country, the outstanding principal of the bond rises with inflation. So, when inflation occurs, the face or par value of the bond rises too. This is in contrast to the inflationary trend with other types of securities, which often decrease in value when inflation rises. And not only the par value adjusts in relation to the cost of the price of goods – so does the interest paid out by the bonds is also adjusted for inflation. By providing these features, ILBs are able to soften the real impact of inflation felt by the holder of the bonds.

The Risk in Inflation-Linked Bonds

While inflation-linked bonds have considerable upside potential, they also possess certain risks. Their value tends to fluctuate not just with the adjustments in the CPI to which they are tied, but also with the rise and fall of interest rates. During deflationary periods — when interest rates are very low — the rate of return for ILBs tends to be less than those of other bond categories.

In addition, TIPS, I-Bonds and many of their global inflation-linked counterparts do not have much value protection during times of deflation. The U.S Treasury, however, does set a floor for TIPS of $100 in par value — the lowest value that the U.S. government will allow it to be redeemed for. But the risk is still considerable, because there are seasoned TIPS issues, carrying years of inflation-adjusted accruals that will always have a greater value.

TIPS and I-Bonds also present complications in trading and taxation that don't affect other fixed-income asset classes. This is largely due to the fact that ILBs have two values: the original face value of the bond, and the current value adjusted for inflation. The adjustments of principal are considered annual income for tax purposes, although investors don't actually receive the adjustments in that year; they get the larger coupon payments that result from them instead. (They only receive inflation-augmented principal when the bond matures.) Thus, investors may be subject to tax on what's known as phantom income. 

The History of Inflation-Linked Bonds

Inflation-linked bonds were first developed in the 18th century to combat inflation's corrosive effects on the real value of consumer goods such as beef, eggs, clothing, shoes, and other essential items during times of rising prices. The Massachusetts Bay Company sold the bonds beginning in the 1780s, for example (but at that time in history few investors were interested).

However, following the rapid economic expansion after World War II, the concept of inflation-linked bonds caught the attention of governmental financial planners. For example, Iceland issued ILBs in the early 1950s to combat high inflation due to their rapid growth in GDP.

Thirty years later, in the early 1980s, the modern inflation-linked bond market began in earnest when Great Britain began to issue ILBs, or "linkers," as they are often called in the United Kingdom. Other countries followed suit including Sweden, Canada, and Australia. The United States did not fully re-enter the ILB market until TIPS were issued in the late 1990s.

The Bottom Line

Inflation-linked bonds operate in a manner much like when they were first issued by the Massachusetts Bay Company more than 200 years ago. The primary difference, however, is that they are now issued by governments rather than companies.

Despite their complex nature and potential downside in deflationary periods, ILBs are still enormously popular because they are the most trusted investment vehicle to hedge against potential inflation. The corrosive effect that inflation can have on returns is a strong motivating factor behind the popularity of these bonds.

An additional upside of ILBs is because they are such a unique investment vehicle, their returns do not correlate with those of stocks, nor (to a lesser degree) with other fixed income asset classes, making them a good diversification instrument for a balanced portfolio.

TIPS and I-Bonds are also an increasingly popular choice for individuals with long-range investing goals, like college education expenses or retirement. Since inflation over a longer time period is much more likely, inflation-linked bonds can help ensure those far-reaching investment targets get hit.