What Exactly is Meant by the Term "Inflation-Protected Bond"?

Definition of Inflation-Protected Bonds, Along with Some Examples

Bonds that are safeguarded against inflation offer protection to investors against price increases. Inflation-protected bonds are referred to as “Treasury Inflation-Protected Securities” (TIPS) in the United States of America. However, in other countries, these bonds are known by a different name. The amount of interest that is paid out on bonds of this sort either rises with inflation or falls when inflation falls below zero. On the other hand, when the note matures, the principal payment will either be an inflation-adjusted principal or the initial principal, depending on which one is bigger.

The following explanation will take you through how inflation-protected bonds operate and how you may invest in them.

What exactly is meant by the term “inflation-protected bond”?

A bond is said to be inflation-protected if it has a payout that moves up or down in tandem with the effects of inflation, and the bond also guarantees either an inflation-adjusted principal or the initial principal, whichever is bigger. The goal of the design is to protect the investor from the fact that inflation makes it harder for them to buy things.

Inflation-linked bonds, inflation-indexed bonds, real return bonds, and Treasury inflation-protected securities are some of the alternative names for these bonds.

ILB and TIPS are both examples of acronyms.

How Does the Operation of an Inflation-Protected Bond Take Place?

Bonds that are safeguarded against inflation have payments that are determined by an index that follows inflation. Since the Consumer Price Index (CPI) is used to measure inflation in the United States, many inflation-protected bonds will have a correlation with the CPI.

If the Consumer Price Index (CPI) goes up, it indicates that inflation is going up, and the inflation-protected bond tied to the CPI will increase the amount of money it pays out to the investor if this happens. When the Consumer Price Index (CPI) goes down, however, payment amounts will go lower. On the other hand, when the note matures, the principal payment will be either an inflation-adjusted principal or the initial principal, depending on which is greater. 

Although the United States has Treasury Inflation-Protected Securities (TIPS), several other nations also have their own in-house versions of inflation-protected bonds. The Canadian government issues “real return bonds.” The United Kingdom and India both provide investors with access to identical investment options but under different titles such as “inflation-indexed” or “inflation-linked” bonds.

The vast majority of inflation-protected bonds are issued by various branches and agencies of the government. There have been isolated instances of private enterprises issuing their own variants of inflation-protected bonds, but the vast majority of these investment possibilities will come from public authorities.

How to Obtain Bonds That Are Protected Against Inflation

The process of investing in inflation-protected bonds is quite similar to the process of investing in any other kind of bond. In most cases, investors can choose between purchasing a bond, a bond exchange-traded fund (ETF), or a bond fund.

A Purchase of Bonds

The purchase of bonds can be done through a variety of brokers. You might have the option of purchasing bonds either through a “first issue,” which refers to purchasing them directly from the entity that is issuing them, or on the “secondary market,” which refers to purchasing them from an investor who had previously purchased them directly from the entity that is issuing them.

You may also purchase bonds that offer protection against inflation directly from the United States government by using Treasury Direct. Bonds can be purchased through Treasury Direct with a minimum investment of $100.

Buying Bond Funds

If you don’t want the hassle of picking and choosing individual bonds, you may give your portfolio exposure to inflation-protected bonds by investing in matching mutual funds instead. Bonds that are safeguarded against inflation are held by funds such as FIPDX and VIPSX, offered by Fidelity and Vanguard, respectively. These two funds invest solely in Treasury Inflation-Protected Securities (TIPS), as do the majority of funds in the United States, which predominantly trade in TIPS. But you can find funds that invest in inflation-protected bonds from other countries as well.

Investors can increase their exposure to the market without having to make any big choices on their own if they delegate such responsibilities to the manager of the fund they have invested in.

You are required to report and pay taxes on the interest that is received from these bonds. Even if you don’t sell any of your fund shares on your own, you might still be responsible for paying taxes on the income generated by owning a mutual fund. For this reason, many people decide to hold this kind of investment in a retirement account, where they may delay or decrease the taxes that apply to any interest payments or capital gains that they get from the account.

Buying Bond ETFs

The advantages of exchange-traded funds (ETFs) may be more appealing to you than those of mutual funds in the event that you do not intend to keep the inflation-protected bonds in a tax-deferred retirement account. ETFs, in comparison to mutual funds, provide investors with a greater degree of discretion over the manner in which they make tax contributions. This is true for all types of investments, even bonds that are covered against inflation.

Mutual funds and inflation-protected bond exchange-traded funds (ETFs) operate in a manner that is, for the most part, equivalent to one another. Investors purchase an exchange-traded fund (ETF) so that they may have exposure to a diversified portfolio of assets managed by an exchange-traded fund (ETF) manager.

Key Takeaways

  • Bonds that are protected against inflation give investors a way to keep their income from falling because prices are going up.
  • Private corporations have been known in the past to issue inflation-protected bonds; however, the vast majority of these bonds are issued by government agencies.
  • Payments on inflation-protected bonds go up when the rate of inflation goes up, and they go down when the rate of inflation goes down. On the other hand, when the note matures, the principal payment will either be an inflation-adjusted principal or the initial principal, depending on which one is bigger.
  • Investors have the option of purchasing inflation-protected bonds directly from the entity that issued them, as well as purchasing inflation-protected bonds via exchange-traded funds (ETFs) or mutual funds. 

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