By Jason Heath, CFP on August 28, 2023
Estimated reading time: 4 minutes

Why inflation-linked bonds aren’t always the answer to high inflation

By Jason Heath, CFP on August 28, 2023
Estimated reading time: 4 minutes

Inflation-linked bonds can decline in a high-inflation year. Here’s how increases and decreases in inflation impact these types of bonds.

An advisor discusses how inflation affects inflation-linked bonds with clients

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I don’t quite understand how inflation indexed funds works. I thought during high inflation periods of time, like 2022, the fund should have performed well, but in reality it is the opposite. My inflation-linked bond fund had a negative return (about -15%), and even the benchmark is negative. Why is this?
—Ray

Inflation and real return bonds

The most common inflation-linked bonds in Canada are known as real return bonds. They are generally issued by the federal government or provincial governments. Federal real return bonds were originally introduced in 1991; however, the federal government announced in late 2022 that it would stop issuing new ones. Existing federal real return bonds continue to trade in the market.

In the U.S., Treasury Inflation-Protected Securities, or TIPS, are the most common inflation-linked bonds.

How inflation affects real return bonds and funds

Real return bonds are generally impacted by inflation in two ways. First, their principal value is adjusted twice per year based on the Consumer Price Index (CPI) inflation rate. If the CPI rises by 2%, the bonds’ principal rises by 2%. Conversely, if there is deflation, and the CPI declines by 2%, the principal decreases by 2%.

Second, the bonds’ interest payment adjusts based on changes in the principal value. So, subsequent payments on a bond paying 4% interest will have a higher dollar value if the principal value rises.

If you buy a 20-year inflation-linked bond and hold it for 20 years, it should provide a good hedge against inflation over that 20-year period. But most investors do not buy a long-term bond and hold it forever. Most investors hold these bonds through mutual funds or exchange-traded funds (ETFs), and may buy and sell them over time.

A bond’s duration is similar to its term or maturity, but it considers the weighted average time to receive the bond’s future cash flows—both interest payments and the principal. The FTSE Canada Real Return Bond Index, for example, currently has an effective duration of about 13 years.

When interest rates rise—which is typically in response to higher inflation and intended to cool off spending and encourage saving—the value of long-term bonds declines. There is an inverse relationship between interest rates and bond prices. This is because newly issued bonds become more attractive to investors when interest rates rise. Existing bonds fall in price so that their interest payment relative to their principal value is comparable to the new bonds.

For example, if you own a bond paying 4%, and you can buy a new bond paying 5% today—because inflation and interest rates have risen—the 4% bond is not as attractive. An investor would not pay as much for the 4% bond as the 5% bond, assuming they have the same maturity date.

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How interest rates affect bond prices

Bond prices change by about 1% in the opposite direction of an interest rate change for every year of the bond’s duration. So, if interest rates rise by 1%, a bond with a 13-year duration (or a bond fund tracking the real return bond index with a 13-year duration) will decline by about 13%. As a result, the FTSE Canada Real Return Bond Index fell about 14% in 2022. Real return bond funds generally fell about the same and probably worse due to their fees.

So, while your bond principal and interest payments rose a bit due to an uptick in inflation in 2022, Ray, because your bonds are long-term bonds and interest rates rose so much, your overall investment dropped.

For what it’s worth, if you owned a long-term bond fund with the same duration that was not inflation-protected, it would have dropped even more. Long-term bonds can be risky in the short term if interest rates are rising. They can be lucrative if interest rates are falling.

Mind the names of your investments

Investors should be careful about the name of a mutual fund or ETF. It may not necessarily represent the future performance of that fund. Just because a fund name includes inflation, it may not necessarily perform well during a period of high inflation. And bond investors need to be careful about the type of bonds they buy, particularly long-term bonds. Although it does not happen often, bonds can lose money, and 2022 was a good example of a bad outcome for investors.

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About Jason Heath, CFP

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.