Inflation-linked bonds — what's the catch?

Question

This the question Why is there a discrepancy between current inflation rate and I bond rate in the US? I have learned that, at least in the USA, there exist bonds where the yield is guaranteed to be not less than inflation. That sounds too good to be true. In Germany, the inflation is currently 8.6%. If I fix money for 5 years with a savings account, I get in at most 2.7% p.a. with foreign or little-known banks, but with most banks substantially less than 1% (one bank I'm with proudly announced a major increase in their interest paid from 0.001% to 0.1%). Commentary on the high inflation rate points out how savers are losing value on their money. (Of course, they might earn more in the stock market — or they might lose everything. One advice I've heard recommends to only put money in the stock market that one can afford to lose, and in any case doesn't need in the next ten years.)

Are inflation-linked bonds a uniquely American thing, or do they exist in the Eurozone as well? If they really pay a per-annum interest equal to inflation, then what's the catch? Why doesn't everyone who seeks a low-risk investment (a safe way to park their money) buy those rather than putting money in a savings account, where interest rates are always below inflation?

Answer 1

You've already got good answers regarding whether inflation-linked bonds are unique to the U.S. The answers seem incomplete regarding your "what's the catch?" question. The correct comparison for inflation-linked bonds is, clearly, not savings accounts but other government bonds. Since U.S. treasury-issued inflation-protected securities (TIPS) were introduced in 1997, the average real return of U.S. non-inflation indexed bonds has been around 5%. This is of course vastly higher than the official interest rate during much of that time, especially since the great financial crisis.

But most individual holders of bonds hold funds, not single bonds through maturity. Funds hold a basket of bonds with various maturity dates, and often trade these bonds before maturity, so their returns have to do with market fluctuations as well as the interest paid. In general, the market price of a bond goes up with the central bank reduces interest rates (as it now has better guaranteed returns than a newer bond), and that accounts for the majority of the very strong returns in U.S. government bonds going back not just to 1997 but to the 1960's. In the other direction, when central banks increase interest rates (as over the past year), bonds drop in market value. And this applies to inflation-protected marketable securities, too! Indices of the TIPS market dropped precipitously through the early part of this year, along with non-inflation-protected bonds.

I-bonds are a special case, since they're non-marketable, but with strict limits on investment amounts they're largely irrelevant here. That said, again, non-inflation-protected government bonds have generally provided a much better annual real return than I-bonds since World War II, with rare exceptions such as the past year.

Anyway, the answer to why people don't simply buy bonds rather than put money in a savings account is: they do. Nobody with a substantial amount of financial capital uses savings accounts for more than the most trivial proportion of it. Government bonds, not savings accounts, are the standard repository of large pools of risk-averse capital. An investor or broker will very often invest some proportion of a bond allocation in inflation-protected instruments, but as I've explained above they're by no means clearly superior to other government bonds, even before one gets into comparisons with other fixed-income instruments, let alone the equity markets.

Answer 2

Here are some of the I-bond "catches":

• There is a $15,000 yearly purchase limit per SSN/EIN ($10k electronic plus $5k paper). Possibly due in part to their desirable properties, the treasury limits the amount that each person can purchase in a calendar year.

• While for the most part I-bonds can be redeemed early without penalty at any point during their 30-year lifespan, there is an initial 1-year lock up period where you cannot redeem them, plus an additional 4 years where redemption incurs a penalty equivalent to 3 months of interest.

• They are non-marketable. This means that you cannot exit your position before the 1-year lockup has passed, so in some ways they are even less flexible than e.g. a marketable bond where you could immediately recoup part of its value on the market, or a CD where you could exit as soon as needed with a penalty.

If you can live with those catches, I-bonds are a great deal, and no other US Treasury bond really comes close to matching their unique properties. They indeed make a great alternative to a savings account in certain situations, particularly in cases where you are 100% sure that you won't need to access the money early during the 1-year lock up period.

I believe there may also be some info to be gleaned by comparing I-bond rates to TIPS bond rates, which are also inflation-linked but are marketable and don't have the same yearly purchase restrictions as I-bonds.

Answer 3

This is absolutely not a uniquely American thing. A Google search for "Euro inflation bond" brings a lot of results, for example this from Italy. These are generally called "Inflation-linked bonds", or ILBs.

Why doesn't everyone who seeks a low-risk investment (a safe way to park their money) buy those rather than putting money in a savings account, where interest rates are always below inflation?

The risk is that the inflation would be transitory, but the inflation protection the bonds provide is only valuable when holding till maturity (otherwise the market prices the risk and the value drops).

Many ILBs don't actually pay interest, they only provide the inflation protection. Those that do pay interest (e.g.: Israeli Galil series), pay relatively low interest (guaranteed 1% p.a. right now, if CPI is less)

Answer 4

Usually the catch is that the inflation-linked bond's payout is as likely to be less than the payout of a fixed-rate bond as more. Maybe more likely. You are essentially buying insurance on top of a standard bond, and like any insurance there is a cost for that coverage; here that cost is built into the purchase and rates.

Answer 5

I am answering from a Hong Konger’s perspective. The situation can be subtly different but I guess some considerations are valid worldwide.

1. Inflation rates are simply not guaranteed and are affected by a lot of uncontrollable factors (e.g. strong dollars, political reasons, real estate supply). An inflation-linked bond issued by Hong Kong government which matures in Nov 2023 only pays 2.08% p.a, which is only slightly higher than the base rate (2%). At the same time, a 1-year fixed time deposit interest rate is at around 4%.

2. The risks are different. Government bonds suffer from sovereign state default, and if it happens, it doesn’t mean that banks automatically go insolvent. For example, deposits in Hong Kong are insured by a fund that all licensed banks contribute to it, and this is unrelated to government bailouts, so bank deposits may actually be safer. Of course you can buy bonds from other countries, but the inflation rate can be different from yours, and forex risks are involved.

3. Inflation-linked bonds are just bonds, so they suffer from general bond risks, such as interest rate risks. When interest rate rises, the bond prices drop. There’s no such risk for bank deposits. Even for fixed-time deposits, some banks may allow early uplifts without penalty under specific circumstances (such as the first few times in a year).

4. Bonds cannot be bought directly from bank saving accounts. In Hong Kong, inflation-linked bonds are listed in Hong Kong Stock Exchange, so you will need a broker account, need to know how to transfer money in and out, bond ticker symbols (do you think people can easily tell the difference between 4239 and 4252?), and pay fees (commissions, interest collection etc).

5. Buying inflation-linked bonds may require a minimum amount of money, such as $10000. Banks allow time deposits as low as $10, which is also an advantage.

For me inflation-linked bonds are good for hedging inflation risks. It does not mean that it’s the best choice if you aim at passive income.

Answer 6

Inflation linked (IL) bonds are available in several countries. They are also nothing new. The earliest recorded inflation-indexed bonds were issued by the Commonwealth of Massachusetts in 1780 during the Revolutionary War.

Also, since you mentioned auctions in a comment, these are the standard way government bonds (all kinds, not just inflation linkers) are issued in the primary market. Once these bonds are on the secondary market, you can trade them without problems.

Governments of at least the following countries issue IL Bonds: U.S., UK, France, Germany, Canada, Greece, Australia, Italy, Japan, Sweden, Hong Kong, Spain, Israel and Iceland and some emerging markets like Brazil, Mexico, Russia, India and the like.

Apart from single government bonds, there are various funds that invest in inflation linked bonds. See for example

• Erste Bank.
• Vanguard
• Schroders

Since you mention Germany, I assume you are not based in the US. To buy I bonds you’ll need to be one of the following:

• A U.S. citizen, even if you live abroad
• A U.S. resident
• A civilian employee of the U.S. government, regardless of where you live

The problems with inflation linkers:

They are kind of complex as you can probably tell from the question you linked. Even computing interest payments of a fixed rate bond accurately with daycount conventions, or the yield can be complex. However, IL are a very different story.

• Inflation-Indexed securities can have a negative yield as a result of yields being below (expected) inflation.
• Most IL bonds adjust the principal value with the CPI (so in case of deflation, you actually have a declining principle). Some countries like the U.S., Australia, France and Germany offer deflation floors at maturity, which mean that if deflation drives the principal amount below par, you will still receive the full par amount at maturity.
• Similarly, coupons payments vary as they are based on the adjusted principal (in this case there is no floor)
• ILB prices will increase as real yields decline and decrease as real yields rise. If you hold them to maturity, that will not be a real problem.
• If you invest in funds or ETFs, you have an additional problem, namely that they have no maturity date. Since TIPS are highly sensitive to interest rate movements, the value of a TIPS mutual fund or ETF can fluctuate widely in a very short period, and you are not guaranteed to get your principal back.

Overall, they do offer a good inflation hedge though and can be a valuable addition to a diversified portfolio. Why not everyone buys them? Many people do not even know they exist, some who do find the mechanics difficult, others tried, and lost confidence when there was very low inflation or deflation. After all, many countries like the U.S. have not really experienced substantial inflation since 1981.