What is an index-linked bond?
An index-linked bond is one where the interest paid on the capital is tied to a specific price index, most often the Consumer Price Index (CPI). This function keeps investors safe by preventing them from seeing underlying index changes. The bond’s cash flows are changed so that the person who owns it gets a known real rate of return. In the U.S., an index-linked bond is called a TIPS; in Canada, it is called an absolute return bond; and in the U.K., it is called a linker.
How a bond linked to an index works
A person who buys bonds has a bond with a set interest rate. Coupons, which are interest payments, are usually made every six months and show the bondholder their return on their investment. But inflation also rises as time goes on, making the investor’s yearly return less valuable. This differs from returns on stocks and real estate, where dividends and rental income rise with inflation. The government releases index-linked bonds to lessen the effects of inflation.
A bond whose coupon payments are related to an inflation indicator, like the Consumer Price Index (CPI) or the Retail Price Index (RPI), so that they are adjusted for inflation is called an index-linked bond. These investments that earn interest usually give buyers an actual yield plus inflation that has already been added, which protects them against inflation. Real numbers, not nominal ones, determine the yield, payment, and debt amount. The CPI is like the exchange rate that changes the return on a bond investment into a real return.
Investors like indexed-linked bonds because they know what the bond is worth when they buy it, so there is no risk associated with not knowing. Also, these bonds are less likely to go down in value than nominal bonds, which helps buyers keep their buying power.
Index-linked bonds offer an actual yield plus inflation. The yield, payment, and principal are all measured in real terms, not nominal terms.
A Type of Index-Linked Bond
Let us look at two buyers. One buys a regular bond, and the other buys an index-linked bond. Both bonds were sold and bought for $100 in July 2019. They both have the same terms: a 4% payment rate, one year to maturity, and a face value of $100. At the time this was made, the CPI number was 204.
The regular bond has an interest rate of 4% per year, which is $4 ($100 x 4%). When the bond matures, the $100 capital is paid back. At maturity, the bondholder will return the initial amount plus the interest payment, which is $4. This adds up to $104.
If the CPI level in July 2020 is 207, the index-linked bond’s interest and capital value must be changed to account for inflation. An indexation factor is used to figure out the inflation-adjusted capital amount, which is then used to determine coupon payments. You get the indexation factor if you take the CPI value for a specific date and split it by the CPI value on the bond’s original issue date. In this case, the indexation factor is 1.0147, equal to 207/204. So, the inflation rate is 1.47%, and when the bond matures, the owner will get $105.53 ($104 x 1.0147).
The bond has an interest rate of 5.53% per year ($105.53 – $100)/$100 times 100%. If you take the nominal rate and subtract the inflation rate, you get the investor’s actual return rate, which is about 4.06% (5.53%–1.47%).
Conclusion
- In the U.S., index-linked bonds are also known as Treasury inflation-protected securities. They pay interest tied to an index, like the Consumer Price Index (CPI).
- Governments issue index-linked bonds to help lessen the effects of inflation. These bonds pay a real return plus inflation that has already been added.
- Investors benefit from these bonds because they are less changeable than regular bonds. This means that the risk that comes with uncertainty is lower.
