Inflation-Linked Government Bonds (TIPS / KTBi)

As the name says, inflation-linked government bonds are government bonds whose principal rises and falls in step with the Consumer Price Index (CPI). In the U.S. they're called TIPS (Treasury Inflation-Protected Securities); in Korea they're called inflation-linked Korea Treasury Bonds (KTBi).

With an ordinary government bond, the principal is fixed until maturity. Lend $7,400 and you get exactly $7,400 back at maturity. But if prices rose 20% in the meantime, the real purchasing power of that returned amount has shrunk by that much.

Inflation-linked government bonds target this problem. Because they grow the principal by as much as prices rise, they are bonds that aim to protect your 'real purchasing power.'

The core formula is simple. Adjusted principal = face value at issuance × (current price index ÷ price index at issuance). The principal grows in proportion to how much prices rose.

For example, suppose you bought about $7,400 worth of an inflation-linked bond with a 1% coupon rate and prices rose 2%. The principal grows to about $7,550, and because interest is calculated by multiplying this enlarged principal by 1%, the interest paid rises accordingly along with prices.

In other words, the coupon rate itself is fixed, but because that rate is multiplied by the 'principal that has grown with prices,' the interest also grows along with prices. U.S. TIPS adjust the principal daily, while Korea's KTBi typically adjusts it quarterly (every three months).

Just as the principal grows when prices rise, it shrinks when prices fall. This raises the worry, 'could I lose money at maturity?' — but there's a safeguard here.

U.S. TIPS pay, at maturity, the greater of the 'inflation-adjusted principal' and the 'original face value at issuance.' In other words, no matter how severe the deflation, if you hold to maturity, the original face value is guaranteed.

In Korea, inflation-linked Korea Treasury Bonds issued from 2010 onward guarantee the face value (original principal) at maturity. But remember this guarantee applies only 'when held to maturity.' If you sell before then, the market price may have fallen below that level.

It's easy to think, 'if the principal grows when prices rise, then in an inflationary period it must be an unconditional win.' But 2022 was exactly the opposite.

2022 was a year when U.S. inflation soared to its highest level in 40 years, yet the TIPS index actually fell about -19% that year. Inflation grew the principal, but the Fed's sharp rate hikes pushed the real interest rate up by more than 250bp (2.5 percentage points), and bond prices fell by far more than that.

When interest rates rise, bond prices fall. Inflation-linked bonds are, in the end, bonds too, so when real rates spike, the price decline can exceed the growth in principal from the inflation adjustment. This is the 'interest-rate risk' of inflation-linked bonds, and the reason a maximum drawdown appears.

Still, if you hold to maturity, you receive the inflation-linked principal and interest regardless of market price swings. A mid-course price decline is a 'loss that isn't realized unless you sell.'

Taxes: In Korea, inflation-linked Korea Treasury Bonds issued from 2015 onward are subject to interest income tax even on the increase in principal that grows with inflation. Because the tax treatment can differ depending on the issuance date, you need to check.

Liquidity: Inflation-linked Korea Treasury Bonds are listed on the Korea Exchange, but trading volume is very limited. When few people are buying and selling, it can be hard to trade immediately at the price you want.

Low coupon rate: In exchange for the inflation increase being compensated through the principal, the coupon rate itself is set lower than that of an ordinary government bond of the same maturity. It's a trade of 'receiving slightly less interest in return for inflation protection.'