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). They are known by other names in other countries. The interest payout on this type of bond increases with inflation or decreases with deflation. But at maturity, the principal repayment is either an inflation-adjusted principal or the original principal. It depends on whichever is greater.

Here is how these 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 along with inflation. It guarantees either an inflation-adjusted principal or the original principal: whichever is greater. This protects 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. Many inflation-protected bonds will correspond to the CPI.

If the CPI goes up, that means inflation is increasing. The bond linked to the CPI will increase its payments to the investor. And when the CPI goes down, the payments will decline. At maturity, the principal repayment is either an inflation-adjusted principal or the original principal, whichever is greater.

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

Most of these types of bonds are issued by government entities. Some companies have issued their own versions. 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. You have three options: you 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," or on the "secondary market." With first issue, you're buying directly from the issuing entity. With the secondary market, you're buying from an investor who had bought the bond at an earlier point.

Tip

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

Buying Bond Funds

What 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 diverse mix of inflation-protected bonds. Both of those funds contain TIPS; most funds in the U.S. will deal primarily in TIPS. But it is possible to find funds that invest in other countries' versions of these bonds, as well.

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

Tip

The interest paid out on these bonds is taxable income to you. You may accrue taxable income simply by holding a mutual fund. This is true even if you don't personally sell any of your fund shares. For this reason, you may 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 help protect from the negative impacts of inflation.
  • These bonds increase payments when inflation rises, and they decrease payments when inflation falls. 
  • At maturity, the principal repayment is either an inflation-adjusted principal or the original principal, whichever is greater.
  • You can buy inflation-protected bonds directly from issuing entities; or, you can buy ETFs or mutual funds that contain them.