What Is an Inflation-Protected Bond?

Defintion & Examples of an Inflation-Protected Bond

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Inflation-protected bonds are bonds that protect investors from inflation. In the U.S., inflation-protected bonds are known as Treasury Inflation-Protected Securities (TIPS), but they are known by other names in other countries. The interest payout on this type of bond increases with inflation or decreases with deflation. However, at maturity, the principal repayment is either an inflation-adjusted principal or the original principal, whichever is greater.

Here is how inflation-protected bonds work and how you can invest in them.

What Is an Inflation-Protected Bond?

An inflation-protected bond is one with a payout that increases or decreases in step with the effects of inflation, while guaranteeing either an inflation-adjusted principal or the original principal, whichever is greater. The design is intended to protect the investor from the purchasing power erosion caused by inflation.

  • Alternate names: Inflation-linked bonds, inflation-indexed bonds, real return bonds, Treasury inflation-protected securities
  • Acronyms: ILB, TIPS

How Does an Inflation-Protected Bond Work?

Payments for inflation-protected bonds are based on an index that tracks inflation. The U.S. uses the Consumer Price Index (CPI) to calculate inflation, so many inflation-protected bonds will correspond to the CPI.

If the CPI goes up, that means inflation is increasing, and the inflation-protected bond linked to the CPI will increase its payments to the investor. Conversely, when the CPI goes down, the payments will decline. However, at maturity, the principal repayment is either an inflation-adjusted principal or the original principal, whichever is greate.

While the U.S. has TIPS, many other countries have their own version of inflation-protected bonds. Canada has "real return bonds." In the UK and India, they offer these same investment products under names like "inflation-indexed" or "inflation-linked" bonds.

Most inflation-protected bonds are issued by government entities. Some companies have occasionally issued their own versions of inflation-protected bonds, but most of these investment opportunities will come from governments.

How to Get Inflation-Protected Bonds

Investing in inflation-protected bonds is similar to investing in any other type of bond. Investors generally have three options, they can buy a bond, a bond ETF, or a bond fund.

Buying Bonds

Many brokers offer a way to buy bonds. You may have the option to buy bonds either "first-issue," which means directly from the issuing entity, or on the "secondary market," which means from an investor who had bought the bond from the issuing entity at an earlier point.

You can also buy inflation-protected bonds directly from the U.S. government on Treasury Direct. You can buy bonds on Treasury Direct in increments of $100.

Buying Bond Funds

If you don't want to pick and choose bonds yourself, you can add inflation-protected bond exposure to your portfolio by buying corresponding mutual funds. Funds like Fidelity's FIPDX and Vanguard's VIPSX hold a diversified mix of inflation-protected bonds. Both of those funds exclusively contain TIPS, and most funds in the U.S. will deal primarily in TIPS. However, it is possible to find funds that invest in other countries' inflation-protected bonds, as well.

By letting a fund manager decide which TIPS to buy and when to buy them, investors can add exposure without having to make any significant decisions on their own.

The interest paid out on these bonds is taxable income to you. You may accrue taxable income simply by holding a mutual fund—even if you don't personally sell any of your fund shares. For this reason, many people choose to own this type of investment in a retirement account where you can defer or reduce taxes on any interest payments or capital gains.

Buying Bond ETFs

If you don't plan on holding the inflation-protected bonds in a tax-deferred retirement account, you might prefer the benefits of ETFs over mutual funds. Compared to mutual funds, ETFs give investors a little more control over how they incur taxes. That's true for all investment areas, including inflation-protected bonds.

Aside from differences in taxation, inflation-protected bond ETFs function largely the same as mutual funds. An ETF manager controls the basket of securities held within the ETF, and investors buy into the fund for a share of exposure to those securities.

Key Takeaways

  • Inflation-protected bonds are bonds help investors protect their income from the negative impacts of inflation.
  • While companies have issued inflation-protected bonds in the past, most are issued by government entities.
  • Inflation-protected bonds increase payments when inflation rises, and they decrease payments when inflation falls. However, at maturity, the principal repayment is either an inflation-adjusted principal or the original principal, whichever is greater.
  • Investors can buy inflation-protected bonds directly from issuing entities, or they can buy ETFs or mutual funds that contain inflation-protected bonds.