Ian answers: To explain how inflation-protected bonds work, consider first how standard bonds work.
A bond is nothing more than a loan made by a company or government.
Individual people and financial institutions, such as pension funds, insurance companies and banks, are asked to lend money to the company or government. The interest on the loan is repaid by a series of regular payments, called coupons. Then the initial amount borrowed, the principal, is paid at the end of the agreement.
For example, if a government borrows €100 million by issuing a 10-year bond with a five percent coupon, it will pay bond holders €5 million each year for 10 years. At the end of 10 years, it will repay the entire €100 million.
A bond is little different from a person taking out an interest only-mortgage. The only difference is that a personal loan typically involves only one borrower and one lender. With bonds, many people and institutions will lend the money because the amount involved will be so large that no single person or company would be able or willing to provide all the funds needed.
See also our video on how bonds work.
Bonds versus inflation-protected bonds
Inflation-protected bonds – also known as index-linked bonds – differ in two ways. First, the coupon payments are not fixed. They change depending on the rate of inflation. Second, the principal repayment will be adjusted for the rate of inflation over the entire life of the loan.
Inflation-protected bonds guarantee the value of both the coupon and the original loan amount even if prices rise. Pension funds and insurance companies are often keen buyers of these bonds because they have made commitments to pay amounts after inflation. Inflation-protected bonds make it easier to meet these commitments.
Inflation-protected bonds guarantee the value of both the coupon and the original loan amount even if prices rise
Governments and companies tend to issue standard, rather than inflation-protected, bonds because they like the certainty of the associated payments. However, they also recognise the role that inflation-protected bonds can play in helping pension funds and insurance companies meet their liabilities. So governments and companies tend to issue a small number of inflation-protected bonds to keep the market alive.
So why don’t they keep up with inflation?
So that’s how inflation-protected bonds work. Now I can answer the second question – why a fund with these bonds doesn’t necessarily keep up with inflation.
Say you bought an individual bond and held it until maturity – this would keep up with inflation. But all the assets the funds own are priced as if they were to be sold immediately.
Consider a bond that paid an inflation-protected coupon of two percent. If interest rates fall and newly issued bonds pay a coupon of one percent, the older bonds paying the higher coupon rate will become valuable. Investors will try to buy them and the price will be pushed up. A person holding these bonds could sell at a profit and get a return higher than inflation.
On the other hand, when interest rates rise, the price of bonds falls, and selling them would give a return lower than inflation.
Charles, the value of the fund you are following could be making a return less than inflation. This could be for two reasons. First, the fund could have bought and sold bonds at the wrong times and made losses. Second, the price of all the bonds the fund holds could be moving up and down because of changes in interest rates.
When interest rates are falling and demand for inflation-protected bonds is strong, the price those bonds can be sold for can rise – even beyond inflation. However, as interest rates were increasing at the time this article was written, their prices were falling.