Portfolio

Do inflation-linked bonds work?

B. Venkatesh | Updated on March 12, 2018 Published on January 07, 2014

These schemes provide a better inflation hedge than fixed deposits.



Here is some food for thought: Do inflation-linked bonds help you achieve your life goals better? The answer, of course, depends on how the bonds are structured and what your investment objectives are! In this article, we discuss why the recent inflation-linked bond issue may not offer you adequate inflation protection, and the kind of bond architecture would help you achieve your inflation-adjusted life goals.

Retirees

You should be concerned about inflation if you are a retiree. Why? Increase in price levels will force you to withdraw more money from your investment portfolio to meet the rising expenses, leaving you with lesser money for later years. This may subject you to longevity risk — the risk that you may outlive your investments.

Inflation-linked bonds should typically help you moderate longevity risk. But the recent bond offering will accumulate and pay the inflation-adjusted interest 10 years hence in December 2023. This means the bond cannot help you meet your current monthly living expenses.

But what if you use the lump-sum money to meet your monthly living expenses beginning January 2024? Your actual cash flow requirement would then depend on the inflation level in 2024, not how inflation was between 2013 and 2023!

Of course, an inflation-linked bond could provide you better inflation hedge for your annual living expenses in 2024 than investing in a 10-year bank fixed deposit today. But you should invest every year in such bonds to continually generate such inflation-adjusted cash flow. And even if the Government were to issue such inflation-linked bonds, will you be inclined to continually looking for such investment opportunities every year? You should preferably look for products that can generate periodic cash flows to meet your living expenses for life such as annuities or at least long-dated monthly income bank deposits.

Working Professionals

As a working executive, you meet your monthly living expenses from your current income. As for your investment objectives, your typical requirements would be to save for your retirement, to fund your children’s education and to meet the down payment to buy a house. Inflation-hedging these investment objectives will be effective only if the inflation index moves in lock-step with education, housing and retirement costs (e.g., health-care costs).

Now, inflation-linked retail bonds will be typically indexed to consumer price index. Both education and housing have lesser than 10 per cent weight in the index. You cannot, therefore, hope to hedge inflation risk in your child’s education fund by investing in an inflation-linked bond. Same is true if you are planning to buy a house. As for your retirement portfolio, investing in a 10-year inflation-linked bond will not serve much purpose unless your retirement is 10 years away. And even then, you will face the same issue that we discussed above for retirees — you will have to scout for such investment opportunities every year!

Of course, the tax argument is also relevant. Why invest in the inflation-linked bond when a tax-free bond offers you 9 per cent interest. The inflation-linked bond will make economic sense if you expect inflation, as captured by the CPI Index, to be above 11.35 per cent per annum.

Conclusion

Inflation-linked bonds would be useful to you as a retiree only if the bond pays periodic coupons. That way, the inflation-adjusted cash flows can help you meet your current inflation-adjusted living expenses. And if you are a working executive, inflation-linked bond will be useful if the inflation index that the bond is benchmarked to is largely aligned to your investment objective. But that is highly unlikely. The recent bond offering may well be the beginning for more meaningful inflation-linked products to come. And that could eventually lay the path for insurance companies to offer inflation-indexed annuities for retirees.

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