What Are Inflation-Linked Certificates of Deposit?
As their name suggests, inflation-linked certificates of deposit (CD) are a type of CD whose interest rates are indexed to the rate of inflation. In exchange for this added protection, inflation-linked CDs generally offer slightly lower interest rates as compared to traditional CDs.
- Inflation-linked CDs are an investment vehicle that provide protection against inflation risk.
- This is accomplished by indexing the interest rate on the investment to a measure of inflation, which is usually the CPI.
- Inflation-linked CDs are a relatively low-yielding instrument, but can be a useful addition to a diversified portfolio, particularly for more risk-conscious investors.
How Inflation-Linked Certificates of Deposit Work
Unlike other assets, such as real estate or publicly traded shares, debt instruments and savings accounts are denominated in dollars as they were valued at the time of the investment. Therefore, if inflation were to increase during the term of the investment, this could erode the real value of the principal returned at the end of the investment term. For this reason, investors who are concerned about inflation may wish to consider investment vehicles that have a built-in protection against inflation risk.
Inflation-linked CDs provide investors with this protection by indexing the CD’s interest rate to the consumer price index (CPI), which is a widely used measure of inflation. If inflation increases during the CD’s term, the increase will be added to the instrument’s interest rate, thereby protecting the investor against interest rate risk. These securities are also insured for up to $250,000 by the Federal Deposit Insurance Corporation (FDIC), making inflation-linked CDs among the safest assets available to investors.
As is often the case in investing, the tradeoff to these risk protections is the fact that inflation-linked CDs generally offer very low yields, typically slightly lower than traditional CDs. One way for investors to increase the interest rate received on their inflation-linked CDs is to agree to lock in their funds for a longer investment period. Typically, the terms for inflation-linked CDs range between six months and six years, with longer periods resulting in higher interest rates.
Real World Example of an Inflation-Linked Certificate of Deposit
Michaela is a real estate investor who regularly buys and sells properties. She is planning to begin construction on a new real estate development in six months, but is concerned that inflation may be on the verge of increasing between now and then. Because she is concerned that inflation might erode the real value of her cash holdings, Michaela decides to invest a portion of her cash into an inflation-linked CD with a term of 6 months.
At the end of the term, Michaela will withdraw her funds in order to help fund her upcoming construction project. In the meantime, the inflation-linked CD will protect her against inflation risk by increasing her interest payments in line with any potential increases to the CPI. In exchange for this security, Michaela must commit to keeping her funds within the CD for six months and must also accept a slightly lower starting interest rate than would be available from traditional CDs.