What are index-linked bonds?
An index-linked bond is a bond in which the payment of principal and interest income is related to a specific price index, usually the Consumer Price Index (CPI). This feature provides investor protection by protecting them from changes in the underlying index. Adjust the bond’s cash flow to ensure that bondholders receive a known real rate of return.Index Linked Bonds are also known as Real Return Bonds in Canada, Treasury Inflation Protected Securities (TIPS) in the US and Linkers in the UK
- Index-linked bonds (also known as Treasury inflation-protected securities in the U.S.) pay interest linked to an underlying index, such as the Consumer Price Index (CPI).
- Index-linked bonds are issued by governments to help mitigate the effects of inflation, paying real yields plus accrued inflation.
- These bonds are good for investors because they are less volatile than regular bonds and reduce the risk involved with uncertainty.
How index-linked bonds work
Bond investors hold fixed-rate bonds. Interest payments, called coupons, are usually paid semi-annually and represent the bondholder’s return for investing in the bond. However, inflation also increases over time, eroding the value of investors’ annual returns. This is different from equity and property returns, where dividends and rental income increase with inflation. To mitigate the effects of inflation, the government issued index-linked bonds.
An index-linked bond is a bond whose par payment is adjusted for inflation by linking the payment to some inflation measure, such as the Consumer Price Index (CPI) or Retail Price Index (RPI). These interest-bearing investments typically pay investors real earnings plus accrued inflation, thus providing a hedge against inflation. Yields, payments and principal amounts are calculated in real terms, not nominal figures. One can think of CPI as an exchange rate that converts bond investment returns into real returns.
Index-linked bonds are valuable to investors because the real value of the bond is known through purchase and the risk involved with uncertainty is eliminated. These bonds are also less volatile than nominal bonds, helping investors maintain purchasing power.
Index-linked bonds offer real yield plus inflation, and everything—yield, payments, principal—is calculated in real terms, not nominal.
An example of an index-linked bond
Consider two investors – one buys conventional bonds and the other buys index-linked bonds. Both bonds were issued and purchased at $100 in July 2019, with the same terms – 4% coupon, 1-year maturity, and a $100 face value. The CPI level at launch was 204.
A regular bond pays 4% interest per year, or $4 ($100 x 4%), and repays the $100 principal at maturity. At maturity, the principal and interest payable, $100 + $4 = $104, will be credited to the bondholder.
Assuming a CPI level of 207 in July 2020, the interest and principal value must be adjusted for index-linked bond inflation. Coupon payments are calculated using inflation-adjusted principal, and an index factor is used to determine inflation-adjusted principal. For a given date, the indexation factor is defined as the CPI value on the given date divided by the CPI on the bond’s original issue date. The index factor in our example is 1.0147 (207/204). Therefore, with an inflation rate of 1.47%, bondholders will receive $105.53 at maturity ($104 x 1.0147).
The bond has an annual interest rate of 5.53% [(($105.53 – $100)/$100) x 100%]. The approximate real rate of return for investors is 4.06% (5.53% – 1.47%), calculated as nominal rate of return minus inflation.