Investing in Inflation-Protected Securities: What You Need to Know

Overview

The spectre of inflation looms large in today’s economic climate. As the cost of living steadily climbs, traditional investments might struggle to keep pace. The continuous rising prices can erode the value of your hard-earned savings. 

In India, Inflation-Protected Securities (IPS), commonly known as Inflation-Indexed Bonds (IIBs), offer a compelling solution, acting as a shield against inflation and safeguarding your purchasing power. 

This blog reads into the world of IPS, aiming to equip you with the knowledge to decide if they’re a suitable addition to your investment portfolio. To extend the knowledge, it dives deeper into its benefits and risks along with the concept of treasury inflation-protected securities.

So let’s begin without wasting a jiffy.

What is Inflation-Protected Securities

Inflation-protected securities (IPS), known as Inflation-Indexed Bonds (IIBs) in India, are a type of bond designed to shield investors from the erosive effects of inflation. Unlike traditional bonds where the principal amount remains fixed, the principal value of an IPS adjusts based on a specific inflation index. 

This adjustment is linked to a specific index, typically the Consumer Price Index (CPI). As inflation rises, the principal value of your IIB increases proportionately, ensuring your investment keeps pace with the rising cost of living.

Treasury Inflation-Protected Securities (TIPS) are a type of inflation-protected bonds (IPBs) that are issued by U.S. government bonds, especially designed to raise the value of your investment with inflation. Their face value is linked to the CPI and adjusts according to changes in the inflation rate. 

The Treasury pays interest on this adjusted face value, resulting in an increasing stream of interest payments as long as inflation rises. Upon maturity, a TIPS investor will receive the original face value along with all the accumulated inflation adjustments since the bond’s issuance. Treasury Inflation-Protected Securities (TIPS) can be a valuable investment tool for individuals nearing retirement, those with a low-risk tolerance, or anyone seeking to protect their savings from inflation.

How Does IPS Work?

Here is the brief of the process that explains how the mechanics behind Inflation-Protected Securities (IPS) function:

• Principal Adjustment: The principal value of an IPS (or Inflation-Indexed Bonds) is adjusted twice a year based on the changes in the inflation index. If inflation rises, the principal increases proportionately. Conversely, if there’s deflation (a decrease in prices), the principal remains constant.
• Interest Payments: IPS pay interest on the adjusted principal value. This ensures that even with inflation, you receive interest on the actual value of your investment, not just the original face value.

Let’s take an example to understand it more precisely. For instance, you invest RS 10,000 in a 10-year IPS with a fixed interest rate of 2%. If inflation rises by 3% in the first year, the principal value of your IPS will be adjusted to RS 10,300. You would then receive interest payments based on this adjusted amount (RS 10,300) for the remaining nine years.

Advantage & Disadvantage of IPS

Akin to other investment and financial instruments available in the market, IPS (Inflation-Protected Securities) or IIB (Inflation-Indexed Bonds) offers a set of benefits and risks that come along as its two sides.

Benefits of Inflation-Protected Securities (IPS)

Here we have breakdown few benefits of IPS or IIBs (Inflation-Indexed Bonds):

Inflation Protection

The primary benefit of IPS is its ability to safeguard your investment from inflation. As the cost of living rises, the value of your IPS grows accordingly, preserving your purchasing power.

Low Risk

Backed by the government, IPS are considered a relatively low-risk investment. Unlike stocks, they are not subject to market volatility and offer a guaranteed return of your principal at maturity (unless held to maturity).

Diversification

IPS can add valuable diversification to your investment portfolio. They provide a hedge against inflation, which can complement other asset classes like stocks and real estate.

Also Read: Portfolio Diversification

Risks of Inflation-Protected Securities (IPS)

With benefits, comes risks. Here we have breakdown few limitations of IPS or IIBs (Inflation-Indexed Bonds) in brief:

Lower Returns

Compared to traditional bonds or stocks, IPS generally offer lower potential returns. The fixed interest rate might not outpace high inflation periods.

Interest Taxed as Ordinary Income

The interest earned on IPS is taxed as ordinary income, unlike some municipal bonds that offer tax-exempt interest.

Deflation Risk

While unlikely, deflation can negatively impact IPS. If prices decrease, the principal value remains constant, potentially leading to missed-out gains on other investments.

How can I invest in (Inflation-Protected Securities) IPS?

There are several ways to invest in IPS, however, there are mainly two ways to invest in IPS (Inflation-Protected Securities)/IIB (Inflation-Indexed Bonds) in India:

• Government Websites: You can purchase IIBs directly from the websites of the Reserve Bank of India (RBI) or authorized government agencies.
• Brokers: Many stockbrokers offer investment services for IIBs. They can handle the purchase and sale process on your behalf.

In Conclusion

Inflation-protected securities (IPS), also known as inflation-indexed bonds, can be a powerful tool to combat inflation and secure your financial future. Such bonds are popular as Treasury Inflation-protected securities (TIPS) is U.S.released by their government. However, they are not a one-size-fits-all solution. It is crucial to consider your risk tolerance, investment goals, and time horizon before incorporating IIBs (Inflation-Indexed Bonds) into your portfolio. You can also opt to consult with a registered financial advisor familiar who can help you determine if IIBs are the right fit for you.

Remember, a well-rounded investment strategy often involves a combination of different asset classes. IIBs (Inflation-Indexed Bonds) can be a valuable addition, offering peace of mind in an inflationary environment.

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