11 November 2008

Inflation Bonds not without problems

Investors looking for a safe haven for their funds and unwilling to take any risk related to investment in Equities are easily tempted to preserve the purchasing power of their savings by investing in inflation-indexed bonds.
These bonds promise to increase the value of the principal at maturity and the interest payments by an amount that is linked to an index that reflects the rise in a price index.
The problem is that the index is usually calculated by a government agency and the rules are set by the finance ministry in the country where the bonds are issued.
Governments in general have every incentive to produce a price index that shows that inflation is lower than it really is.
So it comes as no surprise that a recent study commissioned by the Daily Telegraph in the United Kingdom in Spring of 2008 has found that the Real Cost of Living Index is rising at 9.5 per cent while the official Retail Price Index is shown as rising at a rate of only 4.2 per cent.
This means that an investment in inflation bonds is - while being a sound concept in principle - potentially also a serious risk to the purchasing power of the investor and can only be seen as a partial solution to the preservation of capital in real terms.