Do inflation linked bonds have more volatility risk than the Vanilla bond?
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Inflation-linked bonds are designed to provide protection against inflation by adjusting their principal and interest payments in response to changes in inflation rates. Vanilla bonds, on the other hand, pay a fixed rate of interest and the principal amount is not adjusted for inflation.
Due to their structure, inflation-linked bonds may have more volatility risk than vanilla bonds. This is because changes in inflation rates can cause fluctuations in the market value of ILBs. When inflation increases, the value of an ILB generally increases, since the inflation adjustment to the principal and interest payments makes the bond more valuable. Conversely, when inflation decreases, the value of an ILB generally decreases, as the inflation adjustment to the bond’s payments makes it less valuable.
In contrast, vanilla bonds are generally less volatile than ILBs, because they do not have an inflation adjustment feature. The market value of a vanilla bond is primarily affected by changes in interest rates and credit risk, rather than inflation.
That being said, the actual level of volatility risk associated with ILBs compared to vanilla bonds can depend on a variety of factors, including the level of inflation, the interest rate environment, and the credit quality of the bond issuer. It’s important to consider these factors when evaluating the potential risks and rewards of different types of bonds.