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Inflation-indexed Federal Bonds Protection Against Loss Of Purchasing Power

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Inflation-linked bonds are a bet on unexpected surges in inflation. Interest and repayment are linked to the rate of inflation.The real value of the money invested – the purchasing power – is preserved, no matter how much the prices rise, as long as the real returns are positive at the time of purchase. However, this is currently not the case. In contrast, traditional bonds with longer maturities offer no protection against unexpected inflation . Admittedly, their returns usually include compensation for inflation. But this is, so to speak, a collective estimate of bond buyers that emerges in the market. Ultimately, however, nobody knows how high inflation will be in a year or two.

HOW INTEREST IS PAID ON INFLATION-LINKED FEDERAL BONDS DEPENDS ON THE INFLATION RATE

In contrast, investors can in principle maintain their purchasing power with inflation-linked federal bonds. An example shows how inflation protection works:

An investor who invests 10,000 dollars does not get his 10,000 dollars back as usual after one year, but also an inflation compensation. At 5 percent inflation, he receives 10,500 dollars. Interest is also protected. 1 percent interest – that would be 100 dollars for the 10,000 dollars- becomes 105 dollars. To compensate for inflation, the coupon on indexed federal bonds is significantly lower than that of traditional federal securities. The federal government only pays the inflation adjustment when an indexed bond matures. The compensation payments are more or less accumulated over time. Together with the accrued interest, they are included in the so-called settlement price. This is the price a buyer has to pay the seller if an inflation-linked federal bond changes hands before it matures. The buyer extends the inflation adjustment to which the previous owner is entitled for the federal government. He gets the money back at the end of the term if the federal government pays the entire inflation adjustment.

FINANCE AGENCY SETS PRICES FOR INFLATION-LINKED FEDERAL BONDS ON A DAILY BASIS

Anyone who buys an inflation-indexed federal bond therefore knows for sure what real return they will achieve annually if they hold the paper to maturity. This is especially reassuring when investors are plagued by fears of inflation. With normal bonds, however, the real return is uncertain. It depends on how high the inflation will be in the future. If the inflation rate is above expectations, investors with indexed bonds do better. It is the other way around when inflation turns out to be lower than the market estimates. Incidentally, the expected inflation can easily be calculated by subtracting the real return on an inflation-linked federal bond from the nominal return on a normal federal bond with the same term.

INFLATION-LINKED FEDERAL BONDS ARE A NICHE PRODUCT

Inflation-linked federal bonds are still a niche product. In November 2018, only five with different maturities were traded. The real return on these securities was consistently negative, like that of all other federal securities- assuming inflation moves above a rate of 1.1 percent per year in the coming years. In the case of negative real returns, even inflation-indexed federal bonds do not offer any preservation of purchasing power- and asset growth is certainly not possible. You are a bet on a rising inflation rate, which has a calming effect on the nerves of some investors.

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