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Understanding Inflation-Linked Bonds

Inflation-Linked Bonds (ILBs) are securities designed to hedge investor portfolios from inflation. Primarily issued by sovereign governments, such as the U.S. and U.K., ILBs are indexed to inflation so that the principal and interest payments rise and fall with the rate of inflation. Inflation can significantly erode investors’ purchasing power, and ILBs may potentially hedge against inflation’s effects. ILBs may also offer additional benefits in a broader portfolio context.

What is the impact of inflation on an investment portfolio?

Inflation is an economic term that describes the general rise in prices of consumer goods and services. As prices rise, a dollar saved buys less goods and services, or in other words, investors lose purchasing power of their dollar. To account for the effects of inflation, investors may focus on “real” return - the amount earned after adjusting for inflation. Investments that target returns above the rate of inflation can help preserve and potentially increase investors’ future purchasing power.

Global inflation has been falling since the early 1990s. Over the last decade in the UK, the Consumer Prices Index (CPI) has been between two and three percent, which is broadly in line with the Bank of England’s inflation target. Yet even at a relatively low rate of 2.5%, a basket of goods and services that cost £100 ten years ago would cost £128 today. This illustrates how inflation erodes purchasing power over time.

UK Consumer Prices Index (% Change)
This graphic is a line graph that illustrates the year-over-year percentage change in the UK Consumer Prices Index (CPI) from 1989 to 2023. The y-axis represents the year-over-year percentage change, ranging from -3% to 15%, while the x-axis represents the period of time measured, beginning in 1989 and concluding in 2023. The graph shows various fluctuations in the CPI over the years. Notable peaks occurred around 1990 (11% CPI), 2009 (5% CPI), and 2022 (14.5% CPI). The graphic illustrates that peak inflation periods are often followed by significant dips. There are also significant dips portrayed in the graphic. From 1990 to 1992, inflation sharply declined from 11% to 1%. From 2007 to 2008, it declined from 5% to -1% (this is the only time the U.K. experienced deflation, during the period), and from 2011 to 2015 it declined from 5% to 1%. The most recent peak-and-dip cycle occurred in the early 2020s, reflecting a sharp rise, from 1% around 2020 to 14.5% around 2022, followed by a decline to 5% in 2023. The source of the data is PIMCO and the Office of National Statistics as of January 31, 2024. The graphic includes a disclaimer stating it is for illustrative purposes only and is not indicative of the past or future performance of any PIMCO product. The line graph format allows for a clear visual representation of the changes in the CPI over the specified period.
Source: PIMCO, Office of National Statistics as of 31 January 2024.
For illustrative purposes only. This chart is not indicative of the past or future performance of any PIMCO product.
Growth of ILB Market
This graphic is a bar chart that depicts the growth of the Inflation-Linked Bond (ILB) market from 1997 to 2023.   The y-axis represents the market size in billions of dollars, ranging from $0 to $5,000 Billion ($5 Trillion), while the x-axis represents the years measured, beginning in 1997 and concluding in 2023.   The bars are stacked and color-coded to differentiate between three categories:  1. EM (Emerging Markets): represented in blue  2. Developed countries (excluding the U.S.): represented in green  3. U.S.: represented in purple  The graph shows a significant increase in the ILB market size over the years, with the most substantial growth occurring after 2003.   From 1997 to 2003, ILBs grew slowly and steadily, from a near-$100 Billion total market value to a $500 Billion total value. After 2003, total value began to increase exponentially.   Total market value reached a peak of $4.5 Trillion USD in 2021. In 2022, there was a substantial drop to around $3.75 T. In 2023, market value increased further to $4 Trillion USD.  The U.S. market segment and the Developed ex. US market segments tended to be relatively the same size, over the period measured, with each segment measured as approximately 40% to 45% of the total ILB global market. Each of the two segments, respectively, are far larger than the E.M. segment.   However, from 2020 to 2023, the three most recent years measured, the U.S. segment appears to have overtaken the Developed ex. US segment.   The source of the data is the Components of Bloomberg Universal Government Inflation-Linked All Maturities Bond Index as of December 31, 2023. The Bloomberg Universal Government Inflation-Linked All Maturities Bond Index excludes inflation-linked bonds expiring in less than one year. The graphic includes a disclaimer stating it is for illustrative purposes only and is not indicative of the past or future performance of any PIMCO product.
Source: Components of Bloomberg Universal Government Inflation-Linked All Maturities Bond Index as of 31 December 2023.
Bloomberg Universal Government Inflation-Linked All Maturities Bond Index excludes inflation-linked bonds expiring in less than one year.
For illustrative purposes only. This chart is not indicative of the past or future performance of any PIMCO product.
Principal and Coupon Value, From Issuance to Maturity
This graphic explains how Inflation-Linked Bonds (ILBs) can grow in value over time, focusing on the principal value and coupon value at different stages: at issuance, during life, and at maturity.   The graphic uses a combination of colored bars and gray lines to represent changes in principal and coupon values across the lifetime of the securities, with CPI adjustments illustrated as shaded areas above the initial principal.   The upper part of the graphic depicts lifetime changes in principal value, while the lower part of the graphic depicts lifetime changes in coupon value.   1. Lifetime of principal value:  - At Issuance: Investor pays original principal value.  - During Life: Principal value adjusts with monthly change in CPI (CPI-U, all items, NSA).  - At Maturity: Investor receives the greater of the adjusted or original principal value (referred to as the "deflation floor").  2. Lifetime of coupon value:  - At Issuance: Investor receives a real yield above the principal value and future CPI adjustments; paid semi-annually.  - During Life: Coupon payments vary as the real yield percentage is applied to the CPI-adjusted principal value.  - At Maturity: Coupons are always linked to the CPI-adjusted principal value.  The source of the data is PIMCO, and the graphic is labeled for illustrative purposes only.   Regarding acronyms:   NSA stands for non-seasonally adjusted.   CPI is an abbreviation for Consumer Price Index, a common and universally-respected inflation measure.
Source: PIMCO
Sample for illustrative purposes only.
NSA: Non-seasonally adjusted.

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