Inflation Linked Bonds – Should they be in your portfolio?

Are you worried about inflation? Is now the time to add inflation linked bonds to your portfolio?

To balance the volatility of stocks most experts agree that you should add bonds to your portfolio. Bonds don’t tend to go up as much as stocks, but they don’t tend to go down as much as stocks either.

In fact, when stocks go down it is often the case that certain types of bonds go up. Consequently, by adding bonds, you can still make money, add balance, reduce volatility, and reduce risk.

This article focuses on the difference between nominal bonds and those linked to inflation.

You can find more information about bonds here.

Nominal Bonds

Buying nominal bonds is pretty similar to sticking your money in a savings account, especially a fixed term savings account.

You put your money away for an agreed time period and receive an agreed amount of interest at set intervals. When the period is up you get your money back in full.

The annual interest payment you receive when you buy a bond is called a coupon rate. Historically you would actually have a coupon that you would tear off your bond to claim your money.

If you invested in a £100 bond with a 5% coupon rate, you’d receive £5 per year. This would usually be split into two payments of £2.50, one after 6 months, and another after 12 months.

There are two key differences between investing in bonds and leaving your money in a savings account.

First of all, the interest you receive is usually higher, otherwise why not just stick your money in a savings account. The second difference is that the price of your bonds may go up and down depending on interest rates.

The price fluctuation is only going to impact your returns if you either need your money early or you are trying to make money through speculation.

As long as you wait until the agreed time, you’ll get your money back in full. You will also have made money along the way through interest payments received.

Bond prices change because they are sensitive to interest rates. When interest rates rise and fall, bond values do the opposite. If interest rates rise the price of a bond will go down. If interest rates fall the price of a bond goes up. However, remember, as long as you don’t sell your bonds early, you’ll still get all your money back.

That interest rates impact a bond’s price makes sense. When new bonds are issued their coupon will be based on the new interest rates. If the interest rates go up, a new bonds coupon will be higher.

Nobody is going to choose to buy a bond with a lower coupon if it is priced the same as a new one with a higher coupon. Consequently, the price of the older bond will devalue to take account of this.

On top of that, inflation also causes the real value of the bond to go down. For example if your bond is paying 5% annually but inflation is 7% your interest payments are giving you a real return of -2%. That’s not a good way to make money!

One way to get around this is to invest in short term bonds. This is because bonds with longer time horizons should fall further in price than those with shorter time horizons. The downside of this approach is that shorter term bonds don’t pay as much interest.

Longer term bonds pay higher interest and are more of a diversifier in a portfolio because that is what people tend to buy in times of trouble. Short term bonds don’t pay as much and aren’t likely to go up when stocks crash, but aren’t as sensitive to interest rates.

Another option is inflation linked bonds.

Inflation Linked Bonds

Inflation linked bonds, sometimes called inflation protected bonds or linkers are a little different to nominal bonds. As the name suggests, they are linked to inflation, which means they increase in value along side inflation.

For example, let’s say you invest in a £100 inflation linked bond with a 5% coupon paying £5 per year. Let’s also say that inflation is 10%.

A linker will increase in value by 10% inline with inflation so your bond will now be worth £110. Furthermore, your coupon rate will also increase because 5% of £110 is £5.50.

On the downside, these kinds of bonds usually have marginally lower interest rates or coupons than their nominal bond equivalents.

On the upside, unlike nominal bonds, there is no risk that they are going to lose purchasing power. Furthermore, they don’t correlate particularly well with either stocks or nominal bonds so they add diversification to your portfolio.

Investors who see their bond allocation as another place for yield will probably not want to sacrifice any potential yield for the inflation protection and the diversification inflation linked bonds offer.

However, those who see inflation protection and diversification as a way to make the low risk side of their portfolio even lower risk would probably be wise to add some inflation linked bonds to their portfolio.

With that said, how much of your portfolio should be allocated to inflation linked bonds is open to debate. There are trusted experts out there, such as Larry Swedroe and Scott Burns who advocate 100% of your bond allocation be inflation protected.

Swedroe, in his 1998 book The Only Guide to a Winning Investment Strategy You’l Ever Need, allocates all the bonds be inflation protected.

Similarly, Burns, well known for his Couch Potato Portfolio strategy, suggests investors put half of their money in this type of bond.

Financial author, Rick Ferri doesn’t agree. He suggests a maximum of 20% in this Forbes article.

If you can’t decide then perhaps David Swensen, Chief Investment Officer at Yale University in his book Unconventional Success, has the answer.

His model portfolio divides equally 50/50 between the two.

The fact that the experts don’t agree suggests that the decision isn’t that big.

At the end of the day, if inflation rises or falls pretty much as expected then the return from both nominal and inflation protected bonds will be about the same because they are priced to reflect anticipated inflation.

Only, if inflation actually turned out to be higher than expected would inflation linked bonds provide a higher return than nominal bonds. Similarly, only if the actual inflation was lower than expected would nominal bonds outperform.

Having both kinds of bonds in your portfolio should have you covered in both situations. Going with one or the other probably won’t influence your returns massively over the long term. That is likely to come down to how much of your portfolio is allocated to stocks.