In the U.S., Treasury Inflation-Protected Securities, or TIPS, are the most common inflation-linked bonds.
How inflation affects real return bonds and funds
Real return bonds are generally impacted by inflation in two ways. First, their principal value is adjusted twice per year based on the Consumer Price Index (CPI) inflation rate. If the CPI rises by 2%, the bonds’ principal rises by 2%. Conversely, if there is deflation, and the CPI declines by 2%, the principal decreases by 2%.
Second, the bonds’ interest payment adjusts based on changes in the principal value. So, subsequent payments on a bond paying 4% interest will have a higher dollar value if the principal value rises.
If you buy a 20-year inflation-linked bond and hold it for 20 years, it should provide a good hedge against inflation over that 20-year period. But most investors do not buy a long-term bond and hold it forever. Most investors hold these bonds through mutual funds or exchange-traded funds (ETFs), and may buy and sell them over time.
A bond’s duration is similar to its term or maturity, but it considers the weighted average time to receive the bond’s future cash flows—both interest payments and the principal. The FTSE Canada Real Return Bond Index, for example, currently has an effective duration of about 13 years.
When interest rates rise—which is typically in response to higher inflation and intended to cool off spending and encourage saving—the value of long-term bonds declines. There is an inverse relationship between interest rates and bond prices. This is because newly issued bonds become more attractive to investors when interest rates rise. Existing bonds fall in price so that their interest payment relative to their principal value is comparable to the new bonds.
For example, if you own a bond paying 4%, and you can buy a new bond paying 5% today—because inflation and interest rates have risen—the 4% bond is not as attractive. An investor would not pay as much for the 4% bond as the 5% bond, assuming they have the same maturity date.
How interest rates affect bond prices
Bond prices change by about 1% in the opposite direction of an interest rate change for every year of the bond’s duration. So, if interest rates rise by 1%, a bond with a 13-year duration (or a bond fund tracking the real return bond index with a 13-year duration) will decline by about 13%. As a result, the FTSE Canada Real Return Bond Index fell about 14% in 2022. Real return bond funds generally fell about the same and probably worse due to their fees.
Jason Heath, CFP
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