What Are Inflation-Indexed Bonds? Work and Why Investors Use Them

Inflation-indexed bonds are debt securities designed to protect investors from inflation risk by linking the bond’s principal and/or interest payments to inflation rates. As inflation erodes the purchasing power of fixed income returns, these bonds adjust payouts to maintain real value.

This article explains the concept of inflation-indexed bonds, how they function, and why they might be considered in an investment portfolio.

Inflation-indexed bonds are government or corporate bonds whose principal amount and interest payments adjust according to a designated inflation index, such as the Consumer Price Index (CPI). This ensures that the bond’s real value is preserved despite rising prices.

In India, the government issues such bonds under schemes like the Inflation-Indexed National Savings Securities (IINSS) or similar instruments linked to CPI.

Inflation-indexed bonds are structured to align both interest payouts and principal with inflation, offering built-in protection against rising prices:

Principal Adjustment

The bond’s principal value is adjusted periodically based on inflation data. For example, if inflation rises by 5%, the principal increases by 5%.

Interest Payments

Interest is paid on the inflation-adjusted principal, so as inflation increases, the interest payment also rises.

Maturity Value

At maturity, investors receive the inflation-adjusted principal amount or the original principal, whichever is higher, providing downside protection in deflationary scenarios.

Inflation-indexed bonds offer a range of benefits that make them attractive for conservative and long-term investors:

Inflation Protection

Returns keep pace with inflation, preserving purchasing power.

Lower Interest Rate Risk

Since payouts adjust with inflation, these bonds tend to be less sensitive to interest rate fluctuations compared to fixed-rate bonds.

Predictable Real Returns

Investors receive a guaranteed real rate of return above inflation.

Suitable for Long-Term Goals

Effective for retirement planning or savings intended to maintain value over time.

While offering inflation protection, these bonds come with specific trade-offs investors should evaluate before including them in their portfolio:

Lower Nominal Yield

Inflation-indexed bonds often offer lower nominal yields compared to regular fixed-rate bonds.

Inflation Measurement Lag

Adjustments depend on official inflation data, which may lag actual price changes.

Liquidity Constraints

These bonds may have limited secondary market liquidity compared to traditional bonds.

Tax Implications

Interest and inflation adjustments are taxable as per income tax rules, which could reduce post-tax returns.

Inflation-indexed bonds are often used to add stability and protection in portfolios, especially during periods of rising prices:

• To diversify fixed income portfolios and hedge against inflation
  

• As a stable income source in inflationary environments
  

• To safeguard capital for long-term financial commitments
  

Investors typically allocate a portion of their debt investments to these bonds, balancing inflation risk with growth potential.

The Indian government has been gradually introducing inflation-linked securities to attract risk-averse investors. These instruments are accessible via public issues or through government savings schemes.

Investors should check availability, interest rates, and tenure details with their brokers or financial advisors before investing.

Inflation-indexed bonds provide a valuable tool for protecting investment portfolios from the eroding effects of inflation. By linking returns to an inflation index, they help maintain real purchasing power over time. While they have certain limitations such as lower nominal yields and tax considerations, their role in a diversified portfolio is significant for inflation hedging.

Understanding their features and suitability is important for investors seeking steady, inflation-adjusted income.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.