As we’ve written before, there’s no such thing as a risk-free bond. That’s because it’s impossible to completely remove the two main risks of owning a so-called risk-free bond – default risk and inflation risk. But inflation-linked bonds help investors minimize both.
Default risk has to do with whether or not the bond issuer will pay you back when the bond matures. Government bonds have a lower default risk than corporate bonds. That’s because if they have to, governments can print more money to pay their debts.
Inflation risk is when rising prices (that is, inflation) start eating into the returns you earn on the bond. The difference between the nominal return (which isn’t adjusted for inflation) and the return after inflation is called the “real” return. This is the return that bond investors should focus on.
For example, assume that you buy (at par) a 1-year bond with a 2 percent yield (meaning you’ll earn 2 percent interest per year), and that you expect inflation to be 0.5 percent over the next year. Your expected “real” return (after inflation), assuming that the price of the bond doesn’t move, is 1.5 percent. (For the sake of simplicity we’re ignoring yield to maturity, which reflects the investor’s return if the price of the bond isn’t at 100 when he buys it).
If inflation turns out to be 0 percent, your real return will be 2 percent. But if inflation jumps to 1 percent, your real return will be 1 percent. And if inflation is higher than anticipated, at 3 percent, you’ll actually lose 1 percent in real terms.
The real return is the most important number for investors. If you invest your money for a year, you need to earn more than inflation. Otherwise you wind up losing value.
As this example shows, the nominal return is guaranteed (the 2 percent) but the real return (1.5 percent, after inflation) is not. The real return could turn out to be lower or higher than expected, depending on inflation.
So, even “risk free” government bonds are not risk-free. There is a very small chance the government might default, but the biggest risk is low real returns because of inflation.
Is there any way around this type of risk? The answer is yes: inflation-linked bonds.
Like a regular bond, if you invest $100 in an inflation-linked bond, at maturity you will get $100 back, plus interest. But either the amount you are repaid, or the interest earned while you own the bond, are adjusted for inflation. In other words, the real return is guaranteed, regardless of what inflation turns out to be.
As an example, Thailand offers an inflation-linked bond, with a set interest rate, or coupon, of 1.2 percent per year, that matures in 2021. But its real return is currently 2.16 percent per year, because payments are linked to the inflation rate. This means that if you buy this bond and keep it until it matures in 2021, the interest payments you receive, and the total return of the bond, will increase or decrease depending on the Thai inflation rate.
Or, you could buy a regular bond issued by the government of Thailand that matures in 2020 and pays 2.55 percent interest each year. As of right now, if you own this bond until it matures you’ll earn a nominal (excluding the effect of inflation) return of 1.76 percent per year, because it’s trading above par (at a higher price than which it was issued).
So, the inflation-linked bond currently has a “real” return of 2.16 percent. The regular bond will give you a return of 1.76 percent, minus inflation.
Both bonds are guaranteed by the Thai government, and default risk is low. But the regular bond has an additional risk: inflation. If inflation turns out to be around 1 percent, then the real return on the regular bond will fall to 0.76 percent.
It’s worth pointing out that inflation-linked bonds are attractive whether inflation is high or low. If the inflation rate is high, they pay more, and if inflation is low, they pay less – but will always offer a positive real return.
But what if there is deflation – the opposite of inflation, when prices fall instead of go up? It’s the weak point of inflation-linked bonds. If there is no inflation, there is no change in what inflation-linked bonds pay. If the inflation rate is negative – that is, deflation – the set interest payments of newly issued ILBs could even fall.
Some countries, like the U.S., have a “floor” for the inflation-linked bonds they issue. This means that if there is a long period of deflation, the principal amount of the bond and the fixed interest payments will not fall below their original amounts.
But many countries do not have a “floor” for their inflation-linked bonds. So, there is a risk that the payments, and even the principal amount, could fall below the original value. Since deflation is a very real threat for some countries right now, this is something worth looking out for.
Most developed economies issue inflation-linked bonds, and many emerging markets are also becoming big issuers. Over the last few years, much of the growth in inflation-linked bonds has come from Asia: Thailand (iLB’s), South Korea (KTBi’s), India (IIB’s / CIB’s) and Hong-Kong (iBond’s) all now issue inflation-linked bonds. More are expected to follow.
But it’s difficult for individual investors to buy an actual inflation-linked bond. They’re usually sold to big institutions. There are, though, some ETFs (exchange traded funds) that give investors access to inflation-linked bonds. One of the biggest is the PIMCO Global Inflation-Linked Bond Active ETF (ticker: ILB), which is traded on the New York Stock Exchange. This gives you access to inflation-linked bonds issued by governments around the world.
For investors, the real rate of return is what matters. Inflation-linked bonds issued by governments help investors reduce both default risk and inflation risk.