Passive Income Series - Part III - Inflation Indexed Bonds

Often when planning for regular income sources for retirement, the biggest issue is inflation. Today a bond might be giving a regular coupon payments. The problem comes when over the long term when inflation might lessen the buying power of the same coupon payments. One of the ways to protect against inflation is to invest in inflation indexed bonds. The coupon to be paid each year is adjusted for inflation, thus effectively earning you a real return.

How does it work?

Typically the principal amount of the bond itself will grow with the inflation rate while the coupon % will remain constant. Hence, you are effectively receiving a higher coupon as a percentage of higher principal notional. At the end the principal amount paid is enhanced by the cumulative inflation for the years of the bond's existence.

Example

Let's say there is a $100 bond today, with a real coupon of 4% per year. The notional is inflation indexed. If the inflation is 2% for year 1, the notional at the end of year 1 becomes 102. Now 4% coupon is paid on this new notional, equal to $4.08. Now this coupon might not seem completely adjusted for inflation, but the principal is fully adjusted. So, on redemption effective return would be adjusted for inflation.

Is this a good investment?

If one is looking for low risk income generation strategies, inflation indexed bonds provide a good solution. However, the returns are typically low as compared to stocks over the long run. So, a good mix of both these asset classes can enhance returns while provide a fair amount of diversification. The problem is not all countries issue inflation indexed bonds. Further, one has to think about sovereign default risk which is increasingly an issue with crisis in Greek, Cyprus and other European countries.