Why I’m Investing In Inflation Bonds To Protect My Wealth

Takeaways

• What are inflation bonds

• Why you can profit from inflation

• Opportunities to buy them in multiple currencies

What are Inflation bonds?

Inflation bonds are an asset which combine an investment return which is linked to inflation, whilst promising to repay the capital at the end of the bond's life. 'Promising' is a strong word and should be taken with caution. If you buy government bonds from reputable governments such as the USA or UK you are virtually guaranteed to get your money back.

The investment return of the bond works by paying a coupon. This coupon is set at a nominal - usually small - amount. Where these bonds are attractive is what happens if inflation increases. In such a scenario, the coupon is also increased in line with any increase in inflation. This means you are in effect protected from inflation and are actually profiting!

You should check carefully the bond prospectus before buying a bond, but many inflation bonds also 'uplift' the amount which is repaid to you. This means that if you paid out £100 for (the principal) a bond when it was issued, and inflation has increased by 5%, you can expect to receive £105 back.

Good transatlantic ideas

Both the UK, USA and Canadian governments issue inflation bonds. The UK government was the first to issue them and these are commonly known as 'Linkers'. Their official name is Index-Linked Gilts and it is possible to buy them. In the US these are known as Treasury Inflation Protected Securities and are available in the following ETF.

In Canada, these are known as real return bonds and it is also possible to invest in them. As the US, UK and Canadian economies are large and developed, supported by democratically-elected governments with independent judiciaries , they are safe places to invest your money.

Unorthodox inflation bonds

One slightly unorthodox way of protecting yourself from inflation whilst holding bonds, is premium bonds. These are not inflation bonds but their return can act like a form of inflation protection. Premium bonds are issued by a part of the UK government called National Savings & Investment.

As a result they are guaranteed by the UK government, making them very safe. Premium bonds do not pay a coupon, but your by buying a bond you earn the right the participate in the monthly prize draw. This prize draw pays out amounts as little as £25 but as much as £1 million.

Although winning a prize does not happen often, if you were to win one of the bigger payouts, your return on investment could be substantially higher than what you put in and inflation. You would not only of maintained your purchasing power but also increased your wealth at the same time.

The risk with Inflation bonds

The risk you have is how the government which issues inflation bonds behaves. If it behaves in a fashion where its credibility is questioned, their value can suffer. Therefore the asset you had banked on being safe, can end up being very risky.

An example of this risk is the reaction of financial markets to the UK's disastrous 2022 mini-budget. The UK government set out large spending plans without precise information as to how they would fund it. This spooked markets causing index-linked gilts to sell off as can be seen below:

Wrongly adjusted...

Another risk you incur is that the coupon and principal are not adjusted 'enough' versus the level of inflation you are seeing in your daily shopping. As a result your investment return is not protecting your purchasing power. This occurs because of how the 'uplift' to the coupon and principal are calculated.

This 'uplift' is adjusted in most countries in line with the Consumer Price Index (CPI). This CPI is made up of a basket of goods which are seen as a reflection of that countries' economy. Although broadly the same, CPIs do vary from country to country.

If a particular form of inflation is not captured by the basked of goods included in the CPI which your inflation bond is linked to, then the coupon and principal will not be uplifted. As a result you have lost out. Unfortunately not all risks can be mitigated.

Conclusion

Investing in inflation bonds is often seem as a capital preservation strategy. This is because it provides portfolio protection from interest rate rises. The inflation problem we are all experiencing at the moment is not going to go away soon.

As a result there are going to be increased risks for all investors. This will also lead to large losses as financial events unfold and as people struggle to repay the huge amount of debt in today's world. As a result, investing in inflation bonds which provide a balance between safety, investment return and a form of protection against inflation is wise place for every investor to start.