Inflation-Linked Bonds vs. Nominal Bonds

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Dan Buckley
Dan Buckley is an US-based trader, consultant, and part-time writer with a background in macroeconomics and mathematical finance. He trades and writes about a variety of asset classes, including equities, fixed income, commodities, currencies, and interest rates. As a writer, his goal is to explain trading and finance concepts in levels of detail that could appeal to a range of audiences, from novice traders to those with more experienced backgrounds.

When constructing a portfolio with nominal bonds and inflation-linked bonds, several considerations come into play, particularly concerning the different characteristics and environmental biases of these two types of bonds.

We’ll cover these matters in this article.


Key Takeaways – Inflation-Linked Bonds vs. Nominal Bonds

  • Risk and Inflation Protection:
    • Inflation-linked bonds offer some protection against inflation (their coupon is adjustable based on inflation) and are preferable in high-inflation environments.
    • Nominal bonds provide more stability (fixed coupons) but are vulnerable to inflation eroding their real value.
  • Interest Rate Sensitivity:
    • Nominal bonds are limited in price appreciation potential when interest rates are near zero.
    • Inflation-linked bonds can benefit from negative real interest rates. They can offer more flexibility in diverse economic conditions.
  • Diversification Benefits:
    • Including both bond types in a portfolio provides diversification, balancing stability and inflation protection, and catering to varying economic scenarios.


Nominal Bonds

Interest Rate Sensitivity

Nominal bonds are sensitive to changes in interest rates.

When interest rates fall, the price of existing bonds with higher rates rises.

However, there’s a lower bound to how much nominal interest rates can fall – typically around zero or slightly below (negative rates in some cases).

This limit implies that the potential for price appreciation in nominal bonds due to falling interest rates is capped.

Best Performance Environment

Nominal bonds tend to perform best in environments where both growth and inflation are lower than expected.

In such scenarios, central banks may reduce interest rates to stimulate the economy, leading to an increase in the price of nominal bonds.

Related: Risk Parity Portfolio Construction


Inflation-Linked Bonds

Inflation Protection

Inflation-linked bonds, such as TIPS, provide a hedge against inflation.

Their principal and interest payments are adjusted based on inflation rates, protecting investors from the eroding effects of rising prices.


A common misbelief, however, is that higher inflation means these bonds will do well.

High inflation does not mean that inflation-linked bonds will increase in price.

They are still interest-rate-sensitive instruments.

Since interest rates tend to rise when inflation expectations rise, higher inflation can actually make inflation-linked bonds fall in value.

Their coupon, however, may be adjusted upward if inflation is higher.

A pure inflation instrument is an inflation swap, not an inflation-linked bond.

Related: Inflation Derivatives

Real Interest Rates Consideration

Real interest rates (interest rates adjusted for inflation) can go well below zero, unlike nominal rates.

This characteristic means that in a deflationary environment or when inflation is lower than expected, the real yield can go negative, potentially leading to price appreciation.

Performance in Different Environments

Inflation-linked bonds are typically favored in scenarios where growth is below expectations, but inflation is higher than expected.

They offer a unique combination of providing some hedge against inflation while also being sensitive to economic growth.


Risk and Return Profiles of Inflation-Linked and Nominal Bonds

Analyzing Volatility and Stability

Inflation-linked bonds tend to be more volatile due to their inflation adjustment mechanism.

Nominal bonds are generally considered more stable but are vulnerable to inflation eroding their real value.

Yield Comparisons Between Bond Types

The yields on nominal bonds are typically higher than on inflation-linked bonds in low-inflation environments.

However, in high-inflation scenarios, the adjusted yields on inflation-linked bonds can become more attractive.


Impact of Inflation and Economic Growth on Bond Types

Effect of Rising Inflation on Bond Values

Rising inflation erodes the purchasing power of the fixed payments from nominal bonds.

This makes them less attractive.

In contrast, inflation-linked bonds become more valuable as they offer protection against inflation.

Economic Slowdowns and Bond Performance

During economic slowdowns, nominal bonds often perform better as central banks may lower interest rates to stimulate the economy, increasing the value of these fixed-income securities.


Interest Rate Sensitivity: Nominal Bonds vs. Inflation-Linked Bonds

Understanding the Zero Lower Bound in Nominal Bonds

Nominal bonds have limited potential for price appreciation when interest rates are near zero, as there’s minimal room for further rate cuts.

Real Interest Rates and Inflation-Linked Bonds

Real interest rates, which consider inflation, can fall below zero.

This characteristic gives inflation-linked bonds a unique advantage, as their yields can adjust downward in deflationary environments, leading to potential price appreciation.


Diversification Strategies with Inflation-Linked and Nominal Bonds

Blending Bond Types for Risk Management

A mix of nominal and inflation-linked bonds can provide a balanced approach to risk management.

This is because they can cater to different economic scenarios.

In deflationary environments, your nominal bonds might do better.

In rising-inflation environments, your inflation-linked bonds might perform better than your nominal bonds.

Asset Allocation Based on Economic Forecasts

Investors may tactically adjust their bond allocations based on economic forecasts, favoring nominal bonds in low-inflation scenarios and inflation-linked bonds when higher inflation is expected.

Or they may simply have a mix as part of their long-term strategic asset allocation mix.


Inflation Protection: The Role of Inflation-Linked Bonds

Hedging Against Inflation Risk

Inflation-linked bonds are essential for investors looking to protect their portfolios from inflation in some way.

This can also include assets like commodities (which are often a source of inflation) or certain types of commodities or assets that do well in rising inflation or rising nominal growth environments.

Inflation-Linked Bonds in High Inflation Environments

In environments with rising inflation, these bonds provide a coupon that’s partially dependent on the measured inflation rate.


Portfolio Allocation: Balancing Nominal and Inflation-Linked Bonds

Strategies for Different Investor Profiles

The allocation between nominal and inflation-linked bonds should align with an investor’s risk tolerance and investment objectives.

Adjusting Bond Allocation Over Time

Investors might need to adjust their bond portfolio mix as economic conditions evolve, interest rates change, and inflation fluctuates.


Interest Rate Floor Impact on Nominal Bonds

Constraints of the Zero Lower Bound

The zero lower bound on nominal interest rates can limit the potential for price appreciation in nominal bonds – especially during periods of low or negative interest rates.

Scenario Analysis: Near-Zero Interest Rates

In scenarios of near-zero interest rates, the dynamics of bond pricing and yields are significantly altered, affecting the risk/reward of nominal bonds.

This is because you have little upside when rates are near zero but a lot of downside if interest rates start going the other way.


Portfolio Construction Considerations


Including both nominal and inflation-linked bonds in a portfolio can provide diversification benefits.

Nominal bonds offer stability and potential gains in low-inflation, low-growth environments.

Inflation-linked bonds offer protection against inflation and can perform well in different economic scenarios.

Inflation Expectations

Investors should consider their expectations for inflation when deciding the allocation between nominal and inflation-linked bonds.

If higher inflation is anticipated, a greater allocation to inflation-linked bonds might be prudent.

Portfolios are generally overweight “low inflation assets” (e.g., stocks, nominal bonds) and typically underweight “high inflation assets” (e.g., commodities, bonds linked to inflation).

Interest Rate Outlook

The expected path of interest rates is also important.

If interest rates are expected to fall significantly, nominal bonds might be more attractive due to their potential for price appreciation.

However, if interest rates are near the zero lower bound, the room for further price appreciation due to rate cuts is limited.

Economic Conditions and Monetary Policy

The current and projected economic conditions, as well as central bank policies, should inform the bond allocation.

In a period of aggressive monetary easing, nominal bonds might be more favorable, whereas in times of rising inflation expectations, inflation-linked bonds could be more advantageous.


FAQs – Inflation-Linked Bonds vs. Nominal Bonds

What are the differences between inflation-linked bonds and nominal bonds?

Basic Definitions and Differences

Inflation-linked bonds and nominal bonds are two primary types of debt instruments, differing mainly in how they react to inflation.

Inflation-linked bonds, such as Treasury Inflation-Protected Securities (TIPS) in the US, have their principal and interest payments adjusted based on inflation rates.

Nominal bonds, conversely, have fixed interest payments and principal values. They’re unaffected directly by inflation.

How Inflation-Linked Bonds Work

The principal value of inflation-linked bonds increases with inflation, protecting the purchasing power of the investor.

Consequently, the interest payments, which are a percentage of the principal, also increase with inflation.

Characteristics of Nominal Bonds

Nominal bonds pay a fixed rate of interest throughout their life.

Their value can be impacted by inflation indirectly, as inflation expectations influence interest rates and, in turn, bond prices.



The choice between nominal and inflation-linked bonds in a portfolio depends on a range of factors, including inflation expectations, interest rate outlook, economic conditions, and the trader’s/investor’s risk profile.

A balanced approach that incorporates both types of bonds can offer a more resilient portfolio across various economic scenarios.