What is inflation-indexed security?

Inflation-indexed security is defined as a financial instrument that guarantees a rate of return that is higher than the rate of inflation assuming its holder retains it until its maturity.

Inflation-indexed securities can come in various forms but are often represented by bonds or notes. Investors looking for lower-risk returns frequently choose to hold inflation-indexed securities. These types of low-risk securities generally carry lower coupons compared to high-risk ones.

How does inflation-indexed security work?

These securities aim to protect investors from inflation risks by linking the principal with a nationally recognised inflation index daily, such as the Consumer Price Index (CPI) in the US or Retail Price Index (RPI) in the UK.

By linking the security to an inflation index, the principal and interest received by investors are protected from inflationary erosion.

The principal of inflation-indexed securities rises when inflation begins to climb. By contrast, the value of other types of bonds typically falls at such times.

Naturally, inflation-indexed security means that principal will also decrease during periods of deflation. For example, an inflation-index bond can have a 3% coupon when the inflation rate is 2%.

According to global investment management firm Pimco, the Commonwealth of Massachusetts issued the first inflation-indexed bonds in 1780 during the Revolutionary War.

The UK was the first developed economy to introduce inflation-index securities, or "linkers", to the market. Other countries followed its lead, including Australia, Canada, Mexico, and Sweden.

Examples of inflation-indexed securities

In the US, Treasury Inflation-Protected Securities (TIPS) are one example of a type of inflation-indexed security. Sold by the US Treasury, they are tied to the Consumer Price Index (CPI).

According to Treasury Direct, “Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.”

The United Kingdom Debt Management Office issues inflation-linked gilts that track the country’s RPI. According to its website: “The UK was one of the earliest developed economies to issue inflation-indexed bonds for institutional investors, with the first index-linked gilt issue being in 1981.”

“Index-linked gilts differ from conventional gilts in that both the semi-annual coupon payments and the principal payment are adjusted in line with movements in the General Index of Retail Prices in the UK (also known as the RPI),” the UK Debt Management Office added.

Other countries that offer inflation-indexed securities include Canada and India.

Benefits and risks of inflation-indexed securities

Inflation-indexed securities help investors hedge against the corrosive impact of inflation on a security’s principal. The coupon paid is also adjusted for inflation. Therefore, inflation-indexed securities cushion the real effects of inflation for their holders.

The downside of inflation-indexed securities comes from deflation and the fact that their value fluctuates according to interest rates.

In the case of TIPS, the security has two values – the original face value and the current value adjusted for inflation – which may create trading and taxation complications that don't arise with other fixed-income assets.

In the US, for instance, the adjustments of principal are considered as annual income for tax purposes. But as investors do not receive the larger coupon payment until the bond matures, they may be taxed on income they haven’t yet received.