Investors usually focus on the nominal rate of return on their investment, but what really matters is the actual rate of return. So, if someone told you there was a security that guaranteed real returns over inflation without credit risk, of course you would be interested.
When constructing a portfolio, investors should aim to increase the risk-adjusted return of the portfolio. To do this, they need to look for uncorrelated asset classes. While fixed income securities and equities are most often combined in a portfolio for this purpose, there is another asset class that offers further diversification potential with minimal effort and cost.
Since the early 1980s, inflation-protected securities (IPS) have gradually grown in many developed markets around the world. No other security package is as robust on a risk-adjusted basis.
What are inflation-protected securities?
When you buy a regular bond, you know what the nominal return will be at maturity (assuming no default). But you don’t know your real rate of return because you don’t know what inflation will occur over the life of your bond. IPS is the opposite. IPS does not guarantee you a nominal return, but a real return. So you know your real rate of return, but not your nominal rate of return. Again this is because you don’t know the inflation rate over the life of the IPS.
While the structure of inflation-protected securities is similar to that of regular bonds, the main difference is that the IPS structure for the interest payment is divided into two parts instead of one. First, principal accrues with inflation over the life of the IPS, and the full accrued principal is paid at maturity.
Second, regular interest payments are based on real yields. While coupons on IPS tend to be significantly lower than coupons on regular bonds, the interest paid by IPS coupons is the inflation accrued principal, not the notional principal. Therefore, both principal and interest are protected against inflation. Here is a chart showing coupon payments from IPS.
When are they better than bonds?
The timing of buying IPS instead of regular bonds really depends on market expectations for inflation and whether those expectations are realized. However, rising inflation does not necessarily mean that IPS will outperform regular bonds. The attractiveness of inflation-protected securities depends on their price relative to ordinary bonds.
For example, the yield on a common bond could be high enough to exceed the yield on an IPS even if inflation rises in the future. For example, if the real yield of an IPS is 3%, and the nominal yield of an ordinary bond is 7%, inflation must average over 4% over the life of the bond for an IPS to be a better investment. . This inflation rate at which both securities are unattractive is called the breakeven inflation rate.
How to buy inflation-protected securities?
Most IPS have a similar structure. Many sovereign governments in developed markets issue IPS (for example, TIPS in the United States; index-linked gilts in the United Kingdom; and real-rate bonds in Canada). Inflation-protected securities can be purchased individually through mutual funds or ETFs. While the federal government is the primary issuer of inflation-protected securities, issuers can also be found in the private sector and other levels of government.
Should IPS be part of every balanced portfolio?
While much of the investment community classifies inflation-protected securities as fixed income, these securities are actually a separate asset class. That’s because their returns correlate poorly with conventional fixed income and equities. This fact alone makes them ideal candidates to help create a balanced portfolio; plus, they’re the closest thing you’ll see to a “free lunch” in the investing world. In fact, you can realize most of the gains in this asset class with just one IPS in your portfolio. Since inflation-protected securities are issued by sovereign governments, there is no (or minimal) credit risk, so the benefits of further diversification are limited.
Inflation may be fixed income’s worst enemy, but IPS can make inflation a friend. That’s a consolation, especially for those who recall how inflation wrecked fixed income in the 1970s and early 1980s.
Sound too good to be true?
While the benefits are obvious, inflation-protected securities do come with some risks. First, to fully realize the guaranteed real yield, you must hold the IPS to maturity. Otherwise, short-term volatility in real yields could negatively impact IPS’ short-term returns. For example, some sovereign governments issue 30-year IPSs, and while IPSs of this length can be highly volatile in the short term, they are still not as volatile as regular 30-year bonds issued by the same issuer.
A second risk associated with inflation-protected securities is that because the accrued interest on the principal tends to be taxed immediately, inflation-protected securities tend to be more suitable to be held in tax-sheltered portfolios. Third, they are not well understood, and pricing can be both difficult to understand and difficult to calculate.
Ironically, inflation-protected securities are one of the easiest asset classes to invest in, but also one of the most overlooked. Their poor correlation with other asset classes and unique tax treatment make them ideal for any tax-sheltered, balanced portfolio. Since sovereign government issuers dominate the IPS market, there is little risk of default.
Investors should be aware that this asset class does come with its own risks. Long-term problems can create short-term high volatility, jeopardizing guaranteed returns. Also, their complex structure makes them difficult to understand. For those willing to do their homework, however, the investing world does have a near-free lunch. Dig in!