Basics of Inflationary Bonds

Inflationary Bonds, or Inflation Adjusted Bonds, attempt to mitigate one of the biggest problems experienced while investing in bonds. Inflation, or purchasing power loss, can easily ruin the benefits of an investor’s portfolio. Nominal bonds suffer during periods of high inflation; in inflation adjusted terms they may deliver a purchasing power loss. Bonds which adjust to the rate of inflation adjust either the interest or the principal to cancel the eroding purchasing power. These keep track with the inflation rate, reducing your loss of purchasing power.

Inflationary bonds do best when equities and fixed investments typically do worst: high inflation environments. Their success in this area makes them a safeguard when most of your purchasing power is being erased. They have a negative correlation with investments ravaged by inflation.

If inflation is low or deflationary the rate of return on inflationary bonds will be significantly lower than nominal returns. In these cases, heavy investing in inflation adjusting bonds is unwise. You will lose returns that could be gained from nominal bonds providing revenues unhindered by inflation. Since adjusting bonds typically offer lower nominal returns than actual nominal bonds, there is very little reason to purchase large quantities when inflation is low.

You will need to determine the allocation of bonds between nominal and inflationary adjusting bonds. The primary strategy you will use to shift your portfolio’s allocation is based on the expected levels of inflation. Approaching Inflationary bonds in this fashion will help you maintain your balance based on the future outlook, instead of rumor.

The strategy is simple. When you are primarily concerned about inflation risk, you will want to allocate most of your portfolio towards inflation protective bonds. If expected inflation is higher, you will shift your bond portfolio towards higher percentages of inflation adjusting bonds. If expected inflation is lower, you will shift towards higher percentages of nominal bonds. You will always, just for note, have inflationary adjustment assets in your bond portfolio. You should only be changing strategies if the difference is a major shift.

You also have the option to factor maturities into the mix. This applies to inflation adjusting bonds with a fixed interest rate, and adjusts the principal to inflation. If the bonds adjust some of the interest on the bond to inflation, and the rest is fixed, the strategy will work to a limited degree. The entire point is to lock in a high fixed interest rate for a long time, while the principal adjusts to the inflation rate. If the fixed yield is rising, you increase your percentage of inflation adjusting bonds. At the same time, you purchase longer maturities of the same inflation adjusting bonds. When the fixed yields fall, you decrease your percentages of inflation adjusting bonds, and shorter maturities.