When Inflation-Linked Bonds Can’t Beat High Inflation

Inflation and real return bonds

The most common inflation-linked bonds in Canada are called real return bonds. Provincial and federal governments generally issue them. Federal real return bonds were introduced in 1991; however, the federal government announced in late 2022 that it would stop issuing new ones. Existing federal real return bonds continue to trade in the market.

In the U.S., the equivalent securities are Treasury Inflation-Protected Securities, commonly known as TIPS.

How inflation affects real return bonds and funds

Inflation-linked bonds affect investors in two ways. First, the bond’s principal is adjusted periodically to reflect changes in the Consumer Price Index (CPI). If CPI rises by 2%, the principal value increases by 2%; if CPI falls, the principal is reduced accordingly. Second, the interest payments are calculated on the adjusted principal. So a bond with a fixed coupon rate will pay larger dollar amounts when the adjusted principal grows with inflation.

These two features make an inflation-linked bond an effective hedge if you buy and hold the bond to maturity. For example, if you purchase a 20-year inflation-linked bond and keep it until it matures, the inflation adjustments to principal and coupon should protect your purchasing power over that period—assuming the bond issuer does not default.

However, most investors don’t buy individual long-term bonds and hold them to maturity. Instead, many hold holdings through mutual funds or exchange-traded funds (ETFs). Those pooled products buy and sell bonds over time, and their market value fluctuates with prevailing interest rates, bond duration, fund flows and fees.

Duration is a key concept here. It’s a measure of a bond’s sensitivity to interest rate changes, reflecting the weighted average time it takes to receive all payments (coupons and principal). A fund tracking an index of long-dated real return bonds can have an effective duration of more than a decade. The FTSE Canada Real Return Bond Index, for example, has had an effective duration in the neighborhood of 13 years.

How interest rates affect bond prices

Bonds and interest rates move in opposite directions. When interest rates rise, existing bonds with lower coupons become less attractive, so their market prices fall. A useful rule of thumb is that a bond’s price moves roughly by the duration percentage in the opposite direction of a 1% change in yields. So a bond or fund with a 13-year duration could lose about 13% of its market value if interest rates rise by 1 percentage point.

That relationship explains what happened in 2022. Inflation picked up, which prompted central banks to raise interest rates aggressively to cool demand. Even though inflation-linked bonds adjust principal upward as inflation rises, the sharp increase in interest rates pushed long-term yields higher and caused the market prices of long-duration bonds to drop substantially. As a result, many inflation-linked bond funds and their benchmarks recorded steep negative returns in 2022.

Put simply: inflation pushed principal and coupon amounts up a bit, but rising nominal interest rates reduced the market value of existing long-term bonds by a larger amount. If you held the bonds until maturity, the inflation adjustments would help preserve buying power; but when you hold a fund that must mark its holdings to market and may trade bonds frequently, short-term losses are possible when yields move higher.

For comparison, a long-term nominal bond fund with the same duration would likely have fallen even more that year, because it lacks the inflation adjustment to principal. In other words, inflation-protected bonds can mitigate some inflation risk, but they are not immune to interest-rate risk—especially for long maturities.

Practical tips for investors

Names can be misleading. A fund with “inflation” in its name does not guarantee protection against short-term market losses or a perfect hedge during every inflationary period. Check what the fund actually holds and its duration: a fund with a long effective duration will be highly sensitive to interest-rate moves.

Other factors to consider when evaluating inflation-linked bond funds:

• Duration: Shorter-duration inflation-protected funds will be less volatile in a rising-rate environment.
• Composition: Are holdings government-issued real return bonds, or are there corporate inflation-linked bonds with different risk profiles?
• Fees and trading behaviour: Active funds and funds with higher fees often underperform their benchmarks after costs.
• Investment horizon: If you need liquidity and face possible sales in a rising-rate market, short-term price volatility matters. If you can hold to maturity (or your portfolio is designed for the long run), the inflation adjustments will play out over time.
• Diversification and rebalancing: Use a mix of asset classes and consider periodic rebalancing to manage risk.

Long-term bonds can be risky in the short term when rates rise, but they can also produce strong returns when rates fall. Know the trade-offs and choose funds that match your risk tolerance and time horizon.

Mind the names of your investments

Be careful not to assume a fund will behave a certain way just because of its title. “Inflation” in the name doesn’t guarantee short-term protection. Understand the fund’s duration and holdings, and be aware that bonds can lose money in the short term—2022 was a clear example of that risk for long-duration bond investors.

Read more from Jason Heath:

• Market-linked GICs: The pros and cons for investors
• How annuities work in Canada

• Are your deposits at Canadian financial institutions safe?
• Is now the time for retirees to sell stocks and buy GICs?