Inflation Linked Funds, Inflation Linked Bonds

Inflation linked bonds are those bonds that have their principal indexed to inflation. Capital Indexed Bonds (Australia), Inflation-linked Gilt (UK) and Treasury Inflation-Protected Securities (US) are some examples. Inflation linked funds are designed to eliminate the risk of inflation inherent in any investment.

These funds include:

Inflation linked bonds issued by governments of emerging economies.

Corporate inflation linked bonds.

Sophisticated financial instruments, including foreign exchange contracts, interest-rate swaps and derivatives.

How Inflation Linked Bonds Work

The principal of inflation linked bonds increases with a rise in inflation over a period. Consequently, the interest rate is applied to this increased amount. As a result, the interest payment increases over time. The principal is paid back at an inflated amount on maturity. An inflation proxy, such as the Consumer Price Index (CPI), is used to derive the final principal amount. Theinvestor has complete protection against inflation, as long as the inflation rate to which the principal is indexed equals the one determined by the CPI.

Benefits of Inflation Linked Funds

Inflation linked funds offer the following benefits:

• They serve as an effective hedge against inflation. An investor’s portfolio is protected against a stagflation environment, in which government bond returns suffer from the erosion of the value of money.
• These funds have a fairly low correlation to traditional asset classes. This makes them an attractive instrument for building a portfolio with a superior risk-return profile.
• They protect the purchasing power of pension by linking increases in pension to a rise in the CPI.

Demerits of Inflation Linked Funds

The following limitations are inherent in inflation linked funds:

• An investor in inflation linked funds would be exposed to all the normal risks associated with regular corporate debt securities, such as default risk.
• These funds offer poor returns in a deflationary environment.
• Inflation linked funds are sensitive to fluctuations in interest rates and have a shorter duration than government bonds. Dueto this, these funds do not perform as well as government bonds when the bond markets rally.
• The basket by which inflation is measured for indexing these bonds may not match the actual rate of inflation.

Inflation indexed bonds offer a periodic coupon, which equals the product of the nominal coupon rate and the inflation index. An increase in the coupon payments can be the result of a rise in real rates or inflation expectations or both.