Inflation-Linked Bonds: 3 Things You Should Know

By Markets Fool.com

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Inflation-linked bonds protect investors from one of the biggest risks to their wealth: rising prices. But before you dive in, there are three things you should know about this niche corner of the bond world.

1. Most are issued by governments
Inflation-linked bonds are primarily issued by governments, with returns partially based on the level of inflation during the life of the bond.

In the United States, Treasury Inflation-Protected Securities (TIPS) are the predominate type of issue. TIPS pay a fixed rate of interest; however, the principal amount moves up and down based on changes in the Consumer Price Index.

Likewise, the United States also issues Series I savings bonds, which pay a fixed rate of interest plus a variable rate based on changes in the Consumer Price Index. Unlike TIPS, Series I savings bonds do not adjust for inflation with increases or decreases in the principal. Rather, the inflation rate is simply added to the fixed rate of interest paid on the bond. Series I bonds also have the advantage of being protected from loss -- they cannot and will not suffer declines in their value due to negative inflation (deflation).

2. The inflation benchmark can vary wildly from inflation in your expenses
The Consumer Price Index is intended to capture inflation based on price changes on a basket of commonly purchased goods and services. But while the index may do a fine job measuring inflation generally, on an individual level you may experience vastly different changes in inflation in your own budget based on the composition of your expenditures.

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For example, Series I bonds pay interest based on the CPI-U measure of inflation, which includes items like food, rent, prescription drugs, and even tobacco products. As you might imagine, this can lead to some deviation from the inflation experienced by any one person.

More specifically, a homeowner with a fixed-rate mortgage has a very predictable, very stable cost of housing. But the CPI-U includes changes in rental rates, and thus it can over- or understate the impact of inflation on a homeowner.

3. The breakeven rate is critically important
Inflation-linked bonds are just a small subset of the total bond market. It's an alternative to a traditional bond.

Calculating the breakeven rate is central to deciding whether or not an inflation-linked bond makes sense as an investment. Compare the yields on ordinary bonds to inflation-linked bonds to get a sense of the "breakeven" rate -- the inflation rate at which an inflation-linked bond will match the yield on an ordinary bond.

At the time of writing, Series I bonds paid a fixed rate of 0% plus inflation. A five-year U.S. Treasury note with no inflation protection paid 1.5%. Thus, inflation, as measured by CPI-U, needs to be higher than 1.5% for the Series I bond to provide a better return than an ordinary U.S. Treasury note.

Comparing the inflation-linked bond yield to a standard bond or note with a similar maturity date will give you a good way to gauge investors' expectations for inflation, and help you handicap whether or not an inflation-linked bond is a better place to keep your savings.

The article Inflation-Linked Bonds: 3 Things You Should Know originally appeared on Fool.com.

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