Inflation is a continued increase in price levels over a period of time causing a diminishing purchasing power of money. Inflation is most commonly measured by any economy’s Consumer Price Index. From an investor’s perspective, inflation determines the ‘real return’ for any investor i.e. the amount of return an investor may earn after adjusting for inflation. Hence, the rate of inflation is vital as it denotes the rate at which the real value of an investment is eroded.
Apart from affecting the real return inflation creates uncertainty about eventual charges, interest costs and exchange quotes it erodes the underlying cost of a funding and makes it tough to predict and plan against future returns. Barring retail investors, inflation is more complex for institutional investors, especially those attempting to plan for defined future liabilities with a given pension budget. Most of these schemes make inflation linked payments to members so a growth in inflation expectancies consequences in a growth in anticipated liabilities and these in turn create deficits/pension benefit obligations that need to be rectified. Hence, one of the main objectives for investors is to safeguard their investments from inflation. Due to the above objective, funding options which provide investors with this benefit have become widely popular as a hedge in against uncertain future conditions.
One of the investment options in this area have been Inflation Linked bonds (“ILBs”). Within the past decade, ILBs have had favorable performance and low volatility in comparison to different asset classes.1 Inflation linked bonds help in linking returns to inflation for the bond’s life period and hence safeguard the purchasing power. They incorporate two kinds of charge: the real interest that is constant at the start of the time period, and compensation for the loss of buying capability.
ILBs are provided with a fixed real coupon. The nominal coupons whereas the nominal face amount on which coupons are based is calculated by using the change in the (non-seasonally adjusted) inflation fee. This quotient is calculated from the ratio of the reference inflation index on the coupon date or main reimbursement date and the reference inflation rate on the security’s issuance date and is called the “index ratio”. This ratio can be stated as follows:
Due to the above adjustment for inflation, ILBs may be a perfect hedge for establishments whose liabilities vary sharply with the inflation rate, for example, the liabilities of many defined-benefit plans whose obligations are linked to unknown future, wage boom this is strongly correlated to the inflation rate. If such institutions invest in nominal bonds, they are exposed to the risk that, due to a sharp upward increase in inflation, the value in their investment could fall sharply simply because the value of their liabilities increases. Hence Inflation Linked Bonds can be the safest investment tool to safeguard from inflation risk.
DR. NEELAM TANDON
Professor
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