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What are Inflation Indexed Bonds? - Meaning, Features & Calculation
Inflation can significantly erode the purchasing power of your money, making it crucial to find investment options that protect against this risk. Inflation-Indexed Bonds are designed to offer such protection, ensuring your investments keep pace with rising prices. Understanding how these bonds work and their key features can help you safeguard your financial future effectively.
What are Inflation-Indexed Bonds?
Inflation-Indexed Bonds, also known as Inflation Bonds, are a type of government-issued security designed to protect investors from inflation. Simply put, these bonds adjust both their principal value and interest payments based on the inflation rate, as measured by the Consumer Price Index (CPI).
Working of Inflation-Indexed Bonds
When you purchase Inflation Bonds, the principal amount is adjusted periodically based on changes in the CPI. This means that if inflation rises, the bond's principal increases, and if inflation falls, the principal decreases. Consequently, the interest payments, which are calculated as a percentage of the adjusted principal, also vary with inflation.
Features of Inflation-Indexed Bonds
- Inflation protection: By adjusting both the principal and interest payments in line with the CPI, these bonds ensure that your returns are not eroded by rising prices.
- Flexible concept: Inflation-Indexed Bonds offer flexibility as they adjust to inflation rates, ensuring that your investment's real value is preserved. This makes them an attractive option for long-term investors looking to safeguard their purchasing power.
- Interest rate adjustments: The interest rate on these bonds is typically lower than that of traditional bonds. However, since the principal is adjusted for inflation, the effective yield can be higher in an inflationary environment.
- Consumer price index (CPI): The CPI is the benchmark used to measure inflation for these bonds. As the CPI rises, so does the principal value of the bond, ensuring that the real value of your investment is maintained.
- Government-issued bonds: Inflation-Indexed Bonds are typically issued by the government, which guarantees their safety and reliability. This makes them a low-risk investment option for those looking to preserve capital while earning reliable returns.
How is interest calculated on an Inflation-Indexed Bond?
1. Initial principal: The initial principal amount is set when the bond is issued.
2. Adjustment for inflation: Periodically, the principal is adjusted based on changes in the CPI.
3. Interest payment: The interest rate is applied to the adjusted principal to calculate the interest payment. This ensures that the interest you receive reflects the real value of your investment after accounting for inflation.
For example, if you hold a ₹10,000 Inflation-Indexed Bond with a 3% interest rate and the CPI increases by 2%, the principal adjusts to ₹10,200. The interest payment would then be 3% of ₹10,200, ensuring that you earn actual returns.
Inflation-Indexed Bond benefits
- Continuous real returns: Inflation-Indexed Bonds provide continuous real returns by adjusting the principal and interest payments for inflation.
- Diversification: Adding Inflation-Indexed Bonds to your investment portfolio can enhance diversification, reducing overall risk and improving potential returns.
- Long-term consideration: Inflation-Indexed Bonds are ideal for long-term investment horizons, providing a hedge against inflation and ensuring the preservation of capital over extended periods.
Also Read: Maximize returns with short-term investments
Conclusion
Inflation-Indexed Bonds are a powerful tool for protecting your investments from the eroding effects of inflation. By offering continuous real returns, maintaining purchasing power and providing a predictable income stream, these bonds can play a crucial role in your investment strategy. Whether you're a long-term investor or looking for a haven against inflation, Inflation-Indexed Bonds offer a reliable and secure option.
Disclaimer: This article is for information purpose only. The views expressed in this article are personal and do not necessarily constitute the views of Axis Bank Ltd. and its employees. Axis Bank Ltd. and/or the author shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision.
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