Risk & Allocation
How An Inflation-Linked Bond Pays You
Treasury inflation-protected securities adjust their principal with a published price index, which changes both the interest paid and what is repaid at maturity.
An inflation-linked government bond does not pay a fixed amount. Its principal moves with a published price index, and the interest payments move with it, which changes what the yield means.
The adjustment happens to the principal
Conventional bonds have a fixed face amount. Inflation-linked government securities have a principal that is restated in line with a published consumer price index.
The interest rate is fixed, but it is applied to the adjusted principal. As the index rises, the same rate produces a larger payment.
At maturity, the adjusted principal is repaid, with a provision protecting repayment of the original amount if the index has fallen over the life of the security.
The quoted yield is a real yield
Because inflation compensation arrives through the principal adjustment, the yield quoted on these securities is stated in real terms, after inflation.
A conventional bond's quoted yield is nominal and contains whatever compensation for expected inflation the market has priced in.
The difference between the two is often described as a breakeven rate, and it reflects what the market is pricing rather than a forecast anyone has published.
They still respond to real rate changes
Inflation protection is not price stability. If real yields rise, the market price of an existing inflation-linked bond falls, exactly as with conventional bonds.
That is why these securities can lose value in a period of rising inflation, if real yields are rising at the same time. The two forces are separate.
Holding to maturity removes the price question, since the adjusted principal is repaid regardless of what happened to the market price along the way.
Funds behave differently from individual securities
A fund holding these securities never matures. It continually replaces holdings, so the maturity guarantee attached to an individual bond does not carry through to the fund.
Fund duration determines how much the price moves with real yields, and funds holding longer-dated securities move a great deal more than those holding short ones.
Distributions from such funds also vary, reflecting both the fixed rate applied to the securities and the inflation adjustments accruing within them.
Where the tax treatment surprises people
The principal adjustment is an increase in what is owed to the holder, but no cash is received until interest is paid or the security matures.
Tax treatment of that accrual is a specific area with rules that depend on the account it is held in, and it is a matter for a tax professional rather than for general reading.
The structural point stands regardless: what these securities protect is purchasing power at maturity, not the market value shown on a statement in the meantime.
Questions readers ask
Is a target date fund a good default?
For somebody who would otherwise never adjust anything, it does a job that would not otherwise get done. It is weaker where a lot of your wealth sits outside it.
What does to versus through mean?
Whether the fund stops adjusting at the target date or continues reducing risk for years afterwards. The two produce quite different allocations on the day you retire.
