Inflation-linked bond ETFs: how they protect you against inflation

• Level: For advanced
• Reading duration: 5 minutes

• How inflation-linked bonds work
• The benefits of inflation-linked bonds
• The drawbacks of inflation-linked bonds
• Choosing an inflation-linked bond ETF
• Do you need inflation-linked bonds in your portfolio?

Inflation has returned from the dead like a zombie from the grave and just as ugly. But while conventional bonds struggle in an inflationary environment, their inflation-linked counterparts are renowned as a strong inflation hedge that can preserve your wealth and purchasing power. This introductory guide to inflation-linked bonds aims to explain their features, benefits, and drawbacks to help you make an informed decision about their role in your portfolio.

How inflation-linked bonds work

Inflation-linked bonds (also known as index-linked bonds or ‘linkers’) are debt securities issued by governments, municipalities, and corporations. Like conventional bonds, linkers are typically a low risk, low return asset that can help stabilise your portfolio during difficult economic conditions. But unlike conventional bonds, the core purpose of linkers is to act as a powerful anti-inflation tool. Inflation-linked bonds work by increasing their cashflows in line with an official inflation index. For example, if the inflation index jumps 5% then an index-linked bond’s principal and coupon payments will also climb by 5%. This mechanism ensures the bond’s returns keep pace with rising prices. Most Eurozone inflation-linked bonds are linked to the Euro Area HICPx index which stands for the Harmonised Index of Consumer Prices ex-tobacco. Some European linkers may track their country’s CPI rate (the Consumer Price Index), and this is also the standard inflation gauge for US TIPs (Treasury Inflation-Protected Securities). Older UK inflation-linked gilts adjust by RPI (the Retail Price Index) and newer issues by CPI.

The benefits of inflation-linked bonds

The primary role of inflation-linked bonds is as a wealth-preserver that defends your portfolio against the threat of surging inflation. No other asset class has inflation protection built in. No matter how high inflation goes, linker bonds upweight their returns in response. While equity returns outstrip inflation in the long-run, inflation-linked bonds are designed to compensate in the short-term. Moreover, if you hold an inflation-linked ETF for income then you know that your payments will keep up with rising prices. Eurozone linkers are also proof against deflation. If deflation is negative over the lifetime of a bond then it will always pay its original principal amount and associated coupon payments. That’s potentially a very useful feature as prolonged deflation can be quite damaging for the equity portion of your portfolio in particular.

The drawbacks of inflation-linked bonds

When real yields rise, inflation-linked bond prices fall, just as they do with other types of bonds. If yields rise steeply (as they have during the current inflationary cycle) then the capital losses temporarily inflicted on linkers can overwhelm their inflation-resistant cashflows. In other words, your inflation-linked bond ETF may show a decline at the very moment you think it should be outperforming. If yields rise more slowly, then this phenomenon is less likely to occur as the inflation-linked ETF’s increasing principal and coupon payments dominate its price drops. The important thing to remember is that eventually yield rises increase your overall bond returns, though it can take a while. Inflation-linked bonds are also not a perfect hedge against ballooning prices. Your personal inflation rate may be higher or lower than a headline measure such as Euro Area HICPx. Moreover, the adjustment of a bond’s cashflows always lags three months behind its linked inflation index. Linkers also tend not to perform quite as well as conventional bonds in recessions. Thus it’s worth diversifying across both types of ETF: linkers to cover inflation, and conventional bonds to face-off major economic slowdowns.

Choosing an inflation-linked bond ETF

You can quickly check out your inflation-linked ETF options on the justETF screener. Just click on Bonds then set the Bond Type to Inflation-Linked. Tick the boxes of the ETFs you like then hit Compare your selection for a handy overview. To narrow down your shortlist, we have a couple of useful pointers for you on inflation-linked bond ETFs.

1. First of all, the market is dominated by US inflation-linked bond ETFs which usually have the acronym TIPs in their name. But those trackers respond to the American inflation experience. Thus if you live in Europe a Euro inflation-linked bond ETF is a better match for the price pressures you face. Typically these trackers hold German, French, Italian, and Spanish inflation-linked government bonds. Because these linkers are government bonds, you can rest assured that your cashflows are secure because they’re backed by strong sovereign states. You can double-check this by looking at the credit quality of the ETF’s holdings on its webpage. Bonds rated BBB or above are investment grade.
2. The other thing to bear in mind is that inflation-linked bonds with shorter average maturities are a better fit for fast-rising inflation than longer-dated bonds. Most inflation-linked bond ETFs will provide an average maturity metric on their website. The lower that score, the more the ETF’s return is dominated by inflation, and the less it’s affected by yield changes - which is the balance we want to see. The shortest maturity inflation-linked ETFs contain 100% US TIPs. In this case, you’re trading off a less appropriate inflation index against the very short maturities available in trackers focussed on 0-5 year US linkers. If you decide to go down this route then choose a Euro-hedged version of the ETF to avoid taking currency risk.

Do you need inflation-linked bonds in your portfolio?

The bottom line is that study after study shows that inflation-linked bonds are one of the best ways to protect your wealth against accelerating inflation. That’s because their cashflows are uniquely tethered to an official inflation index and so cannot fail to rise along with prices. If inflation runs wild – as it did in Europe during and after both World Wars and during the 1970s – then inflation-linked bonds would be your ultimate defence. Young investors who are just starting out can hope to beat inflation by relying on strong long-term equity returns. But the older you get, the more purchasing power preservation becomes a key objective, and that’s where inflation-linked bonds shine.