Inflation Indexed Bonds Mitigate Risk, But at What Cost?

Many investors have turned towards inflation bonds as a way to protect their investment dollars during uncertain times. These Government Bonds have become a very popular investment tool to include in an investor's portfolio. With these bonds, they are assigned a certain rate of return by the government, depending on how much inflation has occurred over a certain period of time. While it sounds like a great way to mitigate risk over the long-term, you may be giving up more than you are getting. If you can get a better return on your investment by using another method, then these bonds are unnecessary. Here are a few things to consider about inflation indexed bonds and what they can do for you as an investor.

How They Work

Government-issued inflation indexed bonds start out with a base interest rate. For example, depending on when you buy them, you might get a 1% interest rate for the bond. Then on top of the 1% interest rate, the government will give you another certain percentage of return depending on inflation. Depending on the consumer price index that the government uses to determine inflation, they will see exactly how much inflation has gone up during a certain period. If there was a 5% increase in inflation, they will give you another 5% return on your bonds in addition to the 1%. They re-evaluate the inflation every six months and decide exactly what they will pay. Then that amount is what is added on to the money that was invested in the bonds. 

Drawbacks to Inflation Bonds

In theory, this sounds like a pretty solid idea. You can put your money with the federal government and know that it will at least keep up with inflation. When inflation is high, this can be a very valuable strategy to use. However, if inflation does not rise as steadily, you may not be getting very much out of your investment. For example, let's say that inflation only went up by 1% over a two year period. If that happened, you would only be making a very meager return on your investment. You could put your money into a CD or a savings account and make more than that. Therefore, with this type of investment, you are banking on inflation occurring at a pretty regular rate. If it does not, you could be hurting. 

Another drawback to using this type of investment is that the gains in the account are taxable. This means that you have to count these gains on your federal income tax in the year in which they are earned. While this might sound fair at first glance, you need to remember that you are not actually getting any of the money yet. The value of the bond is growing, but you are not actually cashing it in yet. Therefore, you have to come up with money for taxes on income that you are not receiving. With this in mind, there are many other investments that may be a better way to go for you. 

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