Inflation-linked bond ETFs: opportunities, risks and how they work

•Inflation-linked bonds adjust face value and coupons based on price developments
•Price development depends heavily on inflation expectations and real interest rates
• Useful as a defensive portfolio component, but not a replacement for higher-yielding investments such as stocks

What distinguishes inflation-linked bonds from classic bonds

With a conventional bond, both the interest rate and the repayment amount are fixed from the start. That sounds solid, but there is a catch: If inflation rises, the sum paid out ultimately loses purchasing power because it remains the same in nominal terms, but is worth less in real terms. Inflation-linked bonds, often referred to as “linkers” in English or as Treasury Inflation-Protected Securities (TIPS) in the US, solve this problem differently. Their face value is regularly adjusted to an official consumer price index. Because interest payments are calculated as a percentage of this adjusted face value, coupons also rise with inflation. Regardless of how high inflation is, linker bonds adjust their cash flows accordingly. This mechanism is unique among classic bond classes.

Anyone who buys such bonds via an ETF does not have to worry about reinvesting maturing securities themselves. In the ETF, income from expiring bonds is rolled into new or existing bonds according to the index rules. The ETF thus continuously reflects the performance of a portfolio with a constant term structure.

Where the limits of inflation protection lie

Despite the obvious basic principle, in practice these ETFs do not always behave as investors intuitively expect. When inflation is high and rising, that doesn’t mean an inflation-linked fund or index will automatically rise; the opposite is often the case. The reason: With inflation-linked ETFs, it’s not today’s inflation that matters, but rather what will happen to inflation in the next few months, quarters and years, as Eric Jacobson, fixed income strategist at Morningstar, explains. If the market has already priced in an increase in inflation, the ETF price hardly benefits from it.

There is also another factor: when real yields rise, the prices of inflation-linked bonds, like other bonds, fall. In other words: Linker ETFs are also sensitive to interest rate increases, especially if the maturities of the bonds they contain are long. The coupon and market value of the indexed bonds rose nominally with the inflation rate and cushioned some of the losses, writes Stiftung Warentest on developments in phases of rapidly rising interest rates. The cushioning is actually there, but not complete protection.

Another aspect concerns geographical targeting. If you live in Europe, an ETF on Euro Inflation Bonds is better suited to counter the local price pressure than a product focused on US TIPS. US TIPS are linked to the US consumer price index, which can differ from inflation in the euro area. If you want to avoid currency risk, you should either choose euro-denominated products or consider a currency-hedged option.

Term, portfolio share and practical classification

The term of the bonds contained in the ETF has a direct impact on how important the inflation adjustment is compared to interest rate fluctuations. Inflation-linked bonds with shorter average maturities are better suited to rapidly rising inflation than bonds with longer maturities. The lower this value is, the more the ETF’s return is dominated by inflation and the less it is affected by interest rate changes.

The deflation protection is also worth mentioning: If there is a deflation protection during the term of the bonds included deflation In most euro countries, a protective mechanism applies: investors receive at least the original capital amount back at the end of the term. However, current interest payments can be lower in a deflationary phase because they are based on the lower price base.

As a portfolio component, inflation-linked bond ETFs are generally not seen as an independent investment strategy, but as a supplement. ETFs are particularly suitable as a defensive component in a diversified portfolio. They are not a replacement for growth stocks, but rather a supplement to protect against rising prices, says Vanguard, describing the role of these products. Anyone planning for the long term should also keep in mind that although stock ETFs do not offer direct protection against inflation, they often generate long-term returns that exceed the inflation rate. Inflation-protected bond ETFs fulfill a different function: They protect capital from real losses without relying on growth. This distinction is crucial in order to be able to classify them sensibly in the depot.

Jonas Vogt, editorial team at finanzen.net

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