How can you use inflation-protected securities in a fixed income portfolio?

1 What are inflation-protected securities?

Inflation-protected securities are a category of fixed income instruments that have a built-in mechanism to protect investors from inflation. They are issued by governments or corporations and pay a fixed coupon rate plus an adjustment based on an inflation index. The most common inflation index used is the CPI, which tracks the changes in the prices of a basket of goods and services. The adjustment can affect either the principal or the interest payments, or both, depending on the type of inflation-protected security.

3 Benefits of inflation-protected securities

Inflation-protected securities can offer several benefits for fixed income investors, such as preserving the real value of a portfolio and reducing inflation risk. Additionally, these investments can enhance the diversification of a portfolio by providing a hedge against unexpected inflation and having a low or negative correlation with other fixed income assets. By investing in inflation-protected securities, you can maintain the real value of your portfolio, reduce the inflation risk, and improve the diversification of your investments.

4 Drawbacks of inflation-protected securities

Inflation-protected securities are not without drawbacks, however. For instance, they tend to have a lower nominal yield than comparable nominal bonds due to their protection against inflation. This means that you will receive less income from your inflation-protected securities than from your nominal bonds, unless inflation is higher than expected. Furthermore, these securities can have different tax implications in various jurisdictions, so it is important to consult a tax advisor before investing. Additionally, they may have lower liquidity than nominal bonds, particularly during times of market stress or low inflation. This liquidity risk can affect your ability to rebalance your portfolio or meet your cash flow needs.

5 How to diversify your exposure to inflation

Inflation-protected securities can be an effective tool for diversifying your exposure to inflation, but they should not be the only one. Inflation can have different sources and effects on different assets, so you should also consider other ways to hedge against inflation. Investing in real assets, such as commodities or real estate, can provide income and capital appreciation that can offset the impact of inflation on your portfolio. Growth assets, including equities and venture capital, may offer exposure to innovative sectors and companies that can generate value and profitability in an inflationary environment. Additionally, investing in foreign assets denominated in a foreign currency or linked to foreign currencies can offer diversification and protection against inflation in your home currency. Ultimately, inflation-protected securities can be beneficial for fixed income investors who want to protect their portfolio from inflation and diversify their risk. However, they also have some drawbacks and limitations that should be weighed carefully before investing. Therefore, you should consider other types of assets that can hedge against inflation and enhance your portfolio performance.