Could inflation-linked bonds act as inflation armor?

Why is inflation a problem for investors? 

The rate at which the cost of goods and services rises in a particular economy is known as inflation. 

Central banks keep an eye on inflation to maintain a sound and stable economy. The average central bank targets inflation at 2%. If prices grow too slowly or too quickly, they may use a variety of monetary policy measures, such interest rate monitoring or quantitative easing, to either promote or discourage inflation. 

Exogenous factors, however, can also affect the inflation rate. For instance, the after-effects of the COVID-19 pandemic are currently contributing to rising inflation in the United States.

The amount of goods and services that may be purchased with a certain amount of money is reduced by inflation for both businesses and individuals. The value of money is diminished by inflation, and this has an impact on the interest rates that bonds will eventually pay. This is why traditional fixed-coupon bonds lose value when inflation increases, and investors' portfolios do too (i.e., they lose money).

How do Inflation-linked bonds work in a portfolio

Bonds that are linked to inflation gain value when inflation does. Therefore, investors can utilize inflation-linked bonds to reduce the impact of an increase in inflation on the value of their portfolio. 

Bonds that are related to inflation can also be used to express opinions about potential changes in inflation. Since their value rises with inflation, investors who anticipate greater inflation rates than the market predicts can purchase inflation-linked bonds at a favorable price and, if they are correct, sell them for a profit when inflation data is released.

Understanding inflation-linked bonds

Let's use the example of U.S. TIPS to clarify how inflation-linked bonds function (Treasuries Inflation-Protected Securities). The Consumer Price Index (CPI), a compilation of consumer goods and services, is used in the US to calculate inflation. By contrasting the CPI for the current year with a base year, inflation is determined. 

The coupon (the interest) and principle (the amount lent) both rise in proportion to an increase in the CPI. The coupon and principal will be raised by 1 percent to reflect the impact of the increase in inflation, for instance, if it goes from 2 percent to 3 percent.

This is a very important feature because it means the value of the bond increase in an inflationary environment, unlike other types of bonds whose value decrease in such an environment.

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