What is Inflation and Index fund

With the opening up of the economies and the growth in various sectors, numerous enterprises spread over sectors like FMCG, education, banking, automobile, healthcare etc. have been set up which provide the people with goods and services which are needed and essential for the survival as well as improvement in the standard of living. As these enterprises set up and grow, they require funds to operate which can be in the form of equities or debt from the outside investors for a specified or an unlimited period of time. The sources from where such organizations can raise funds can be: equities, loans, mutual funds, debentures, bonds etc.

For regular investors, bonds are very common as an instrument of investment but for the investors who are new and have just started making investments, they may not be well versed with all the details.

Therefore, let us first go about on major details about bonds and then make a detailed analysis of Inflation Indexed Bonds

What are Bonds?
Bonds are a debt instrument used to raise capital and are also known as fixed income security. They are typically a loan agreement between an investor and the issuer of the bond to pay a specified sum of money on a given future date. These are usually issued by governments, municipalities, states and companies to finance some specified projects such as building roads, schools, hospitals, buy property etc. Also bonds could be traded publically, over the counter or privately between the related parties.

What are Inflation Indexed Bonds/Inflation linked Bonds?
Inflation Indexed Bonds are bonds which are indexed to inflation and deflation on a daily basis. They are primarily used to hedge the risk of inflation and related macro-economic variables on the value of the bonds for the investor. The principle and the interest amounts vary with the inflation rates in the country.

Since inflation can significantly affect the purchasing power of the investor, inflation indexed bonds provides the investor with protection and also provide additional benefits in a wider portfolio context.

The first inflation indexed bonds were issued in 1780 by the Massachusetts Bay Company and the market has been growing ever since with a major portion of market held by sovereign bonds and a small portion held by privately issued bonds.

Functioning of Inflation Indexed Bonds
Each country has its own different way of calculating the Consumer Price Index (CPI) because IIBs are related to cost of consumer goods. And also, each country have their own agencies who are authorized to issue these IIBs.

Inflation Indexed Bonds automatically adjusts to the changes in the inflation rates in the economy, i.e., if the inflation increases, the face value or the par value of the bonds rises too in addition to the increase in the interest paid out on the bonds. This stands contrary to other types of securities which show an inflationary trend and often decrease in value when there is rise in inflation.

Now let’s learn about the factors that affect the performance of IIBs

1.Interest rates-

Broadly when interest rates rise, bond prices reduce. When interest rates fall, bond prices increase.
For Example – an investor owns a bond holding 3% interest. When interest rates are low around 1%, the price of the bond becomes higher than the going rate. This makes the bond attractive to other investors. But if interest rates rise to 5%, your bond becomes less attractive.

In general, when inflation is on an upswing, bond prices fall. When inflation is decreasing, bond prices rise because rise in inflation reduces the purchasing power of what the investor earns on his investment. In other words, when a bond matures, the return that have been earned on the investment will be worth less in today’s currency.

3.Credit ratings-
The credit rating agencies allot credit ratings to bond issuers and to specific bonds. These credit rating can provide information about an issuer’s ability to make interest payments and repay the principal on a bond. If the issuer’s credit rating goes up, the price of its bonds will rise. If the rating goes down, it will reduce the bond prices subsequently.

Identifying the risks associated with IIBs

Though IIBs are on an up-swing, they do have some risks associated with them.

  1. The value of the bonds fluctuate not only with the adjustments in the CPI but also with the changes in the interest rates. Thus, in a deflationary situation when the rate of interests are low, the rate of return on such bonds could be even lesser then other bonds categories.
  2. IIBs does not have any tax benefits for the investors like other debt instruments offer. Thus, an investor hesitates while investing in them.

The manner in which the inflation indexed bonds operate are similar to the time they were issued back in 1780, the only major difference is that now they are issued by only the government and not any company.
Even though they have a complex nature of operation they are still popular amongst investors because IIBs are the most trusted instruments to hedge inflation.
Additionally, inflation linked bonds also provide investors with diversification for the ones who are looking for a balanced portfolio since they are very unique and they have no correlation between the returns of stocks or any other fixed income asset classes.

                                                                                                                                            -By Sarah Singh Solanki

Posted On: 01 Aug 2019 Home / Investing / What is Inflation and Index fund