Protect your money from inflation with inflation-linked bonds

Like death and taxes, inflation is a fact of life. But this does not necessarily spell doom and gloom for investors, explains Gareth Bern, portfolio manager at Prudential. Investing in an instrument that adjusts to changing inflation, like inflation-linke

ILB returns are linked to the inflation rate and are adjusted for the effects of inflation

ILBs, as the name suggests, are bonds whose returns are explicitly linked to the inflation rate. They are also referred to as ‘real’ bonds in that they are quoted and priced to provide a return after adjusting for the effects of inflation. “This provides the investor who holds them to maturity with a means to preserve and hopefully grow the purchasing power of their investment,” explains Bern.

Both the interest payments and the principal value of an ILB are adjusted for inflation, which explains the seemingly low yields on ILBs

South African ILBs make interest payments on a periodic basis in much the same way as a traditional fixed rate bond. The difference is that ILB interest payments are adjusted for what inflation has been over the period. Importantly, it is not just the interest payments that are adjusted for inflation but also the principal value of the bond. Bern explains: “The initial principal grows with inflation so that when it is eventually repaid on maturity, the investor receives the initial principal investment plus whatever inflation has been over the period of the investment.”

For example, if an investor bought a one-year ILB for R1 000 and inflation averaged 10% over the year, the maturity value of the bond at the end of the year would be R1 100. If inflation had only averaged 5% for the year, then the investor would receive R1 050 on maturity. The yields on ILBs therefore appear low at first glance because they don’t reflect the additional return the investor will receive to compensate for the effects of inflation.

The bulk of ILB cash flows are only received at maturity, in contrast with fixed rate bonds

In the tables below there is a simplified example of what the cash flows on an investment of R10 000 in an ILB look like compared to a similar investment in a fixed rate bond.

The ILB interest payments are adjusted based on the inflation rate; whereas the fixed rate bonds interest payments remain the same. “Note how the bulk of the cash flows from the ILB are received on maturity of the bond rather than through interest payments,” Bern emphasises. This is because the initial investment is adjusted for inflation but this inflation adjustment is only paid to the investor on maturity of the bond rather than with the annual interest payments.

ILBs don’t carry inflation risk and provide protection against unexpectedly high inflation in contrast to fixed rate bonds

While the ILB investor assumes no inflation risk the fixed rate bond investor retains all the inflation risk. “Although it’s not possible to say with certainty which will be the better investment as one needs to know what inflation will be, the ILB does provide the option to avoid the risk that inflation turns out to be much higher than expected,” explains Bern. In other words, ILB investors can lock in their real rate of return and be protected against unexpectedly high inflation.

ILBs remain a key asset for investors who want to earn an inflation-protected return

For investors looking for an instrument that explicitly protects their investment from the effects of inflation, ILBs provide a useful starting point. If you are an individual investor who wants to access the benefits of inflation-linked bonds, you need look no further than the Prudential Inflation Plus Fund, which had just over 30% of its portfolio invested in these instruments at the end of July 2012.