Index linked bonds

What Is Index Linked Bonds?

Index linked bonds are a type of debt security where the principal value and/or the interest payments are adjusted periodically based on a specific inflation index, such as the Consumer Price Index (CPI). As a category within fixed income, these bonds are designed to protect investors from the erosive effects of inflation on purchasing power. Unlike traditional bonds that pay a fixed coupon based on a nominal principal, index linked bonds offer a measure of protection against rising prices by adjusting their payments in line with changes in the cost of living. This characteristic makes them a valuable tool for investors seeking to preserve the real value of their investment portfolios over time, particularly during periods of high or uncertain inflation.

History and Origin

The concept of inflation-indexed securities emerged in various forms over history, but modern index linked bonds gained prominence in the late 20th century. The United Kingdom was a pioneer among developed economies, introducing its first index-linked gilt (its government bond equivalent) in 1981. This initial issuance was intended for institutional investors, such as pension funds, to help them match their inflation-linked liabilities.⁷, ⁸

Following the UK's lead, other countries began to explore similar instruments. In the United States, after experiencing periods of significant inflation, particularly in the 1970s, the U.S. Treasury launched Treasury Inflation-Protected Securities (TIPS) in January 1997.⁴, ⁵, ⁶ The introduction of TIPS provided individual and institutional investors in the U.S. with a direct means to safeguard their capital against inflation, marking a significant development in the broader debt markets.

Key Takeaways

• Index linked bonds adjust their principal value and/or interest payments according to an inflation index, such as the Consumer Price Index, to protect against inflation.
• They aim to preserve the real purchasing power of an investment, distinguishing them from conventional fixed-rate bonds.
• The United Kingdom introduced the first modern index linked gilts in 1981, followed by the U.S. with Treasury Inflation-Protected Securities (TIPS) in 1997.
• These bonds typically offer lower nominal yields than conventional bonds because of their built-in inflation protection.
• At maturity, investors receive either the inflation-adjusted principal or the original principal, whichever is greater, offering protection against deflation as well.

Formula and Calculation

The mechanics of index linked bonds involve adjusting the principal value based on an inflation index. The interest payments are then calculated based on this adjusted principal. For bonds that adjust their principal, the calculation involves:

1. Adjusted Principal Value:

   $$\text{Adjusted Principal Value} = \text{Original Principal Value} \times \left( \frac{\text{Current Reference Index}}{\text{Base Reference Index}} \right)$$
   • Original Principal Value: The face value of the bond at issuance.
   • Current Reference Index: The value of the inflation index (e.g., CPI) on a specified date near the coupon payment or maturity.
   • Base Reference Index: The value of the inflation index on the bond's issue date or a defined base date.

2. Semi-Annual Interest Payment:

   $$\text{Semi-Annual Interest Payment} = \text{Adjusted Principal Value} \times \frac{\text{Fixed Coupon Rate}}{2}$$
   • Fixed Coupon Rate: The stated interest rate (also known as the coupon rate) determined at auction or issuance. This rate remains constant throughout the bond's life.

For example, if a bond has an original principal of $1,000 and a fixed coupon rate of 1%, and the inflation index moves from 100 at issuance to 105, the adjusted principal would be ( $1,000 \times (105/100) = $1,050 ). The semi-annual interest payment would then be ( $1,050 \times (0.01/2) = $5.25 ). This adjustment ensures that the purchasing power of both the principal and the interest payments is preserved. The final maturity value received by the investor will be the adjusted principal or the original principal, whichever is greater.

Interpreting the Index Linked Bond

Interpreting index linked bonds requires understanding that their primary benefit lies in their ability to maintain real purchasing power, not necessarily to provide higher nominal returns than conventional bonds. The "real yield" of an index linked bond is the yield an investor receives above and beyond inflation. For example, a bond with a 0.5% real yield means the investor earns 0.5% annually after accounting for inflation. This real yield is often what investors focus on when assessing the value of an index linked bond, as it directly reflects the return in terms of goods and services.

Investors typically compare the real yield of an index linked bond to the yield of a nominal (conventional) bond of similar maturity. The difference between the nominal yield and the real yield is often used as a market-implied inflation expectation. A rising implied inflation expectation might suggest that the market anticipates higher inflation in the future. The yield curve for index linked bonds can also provide insights into market sentiment regarding long-term inflation outlooks.

Hypothetical Example

Consider an investor purchasing an index linked bond with an original principal value of $1,000 and a fixed coupon rate of 0.5% (paid semi-annually). The bond's principal is adjusted by the Consumer Price Index (CPI), with the base CPI set at 200 at the time of purchase.

Six months later, the CPI has increased to 204.

1. Calculate the new adjusted principal:
   Adjusted Principal = ( $1,000 \times (204 / 200) = $1,020 )
2. Calculate the semi-annual interest payment:
   Interest Payment = ( $1,020 \times (0.005 / 2) = $2.55 )

If the CPI were to rise further in the next six-month period to 208, the process would repeat:

1. Calculate the new adjusted principal:
   Adjusted Principal = ( $1,000 \times (208 / 200) = $1,040 )
   (Note: The adjustment is always against the base CPI for simplicity in some implementations, or the previous period's CPI in others. For TIPS, it's against the reference CPI for that specific day.)
2. Calculate the semi-annual interest payment:
   Interest Payment = ( $1,040 \times (0.005 / 2) = $2.60 )

At maturity, if the adjusted principal value is $1,060, the investor receives $1,060. However, if deflation had occurred and the adjusted principal fell below $1,000, the investor would still receive the original $1,000 principal at maturity, providing a principal protection feature.

Practical Applications

Index linked bonds are widely used by various entities for several key reasons:

• Individual Investors: For individuals planning for retirement or seeking long-term capital preservation, index linked bonds can be a core component of a diversified retirement portfolio. They provide a reliable income stream that adjusts with inflation, helping to maintain purchasing power throughout retirement.
• Pension Funds and Insurance Companies: These institutions often have long-term liabilities that are implicitly or explicitly linked to inflation. Investing in index linked bonds allows them to hedge against inflation risk, ensuring they can meet future obligations even if prices rise significantly. The UK's first index-linked gilts were specifically designed for pension funds.³
• Institutional Investors and Asset Managers: For large institutional investors, index linked bonds serve as a strategic asset class for managing overall portfolio risk and achieving specific inflation-adjusted return targets. They can be used to construct a liability-driven investment strategy.
• Central Banks and Governments: While primarily issuers, central banks and governments closely monitor the yields and trading activity of index linked bonds as indicators of market inflation expectations. For example, Treasury Inflation-Protected Securities (TIPS) are a direct offering from the U.S. government to investors seeking inflation protection.²

Limitations and Criticisms

Despite their benefits, index linked bonds have certain limitations and criticisms:

• Lower Nominal Yields: Because of their built-in inflation protection, index linked bonds typically offer lower nominal yields compared to conventional bonds of similar maturity. This means that if inflation turns out to be lower than anticipated, or even negative (deflation), the total return from an index linked bond might underperform a conventional bond.¹
• Deflation Risk (for interest payments): While the principal is often protected against deflation (returning at least the original par value at maturity), the interest payments will decrease if the adjusted principal declines due to deflation. This can lead to lower cash flows for investors during deflationary periods.
• Indexation Lag: There is often a lag between the publication of the inflation index and its application to the bond's principal. This "indexation lag" means that the bond's adjustments may not perfectly reflect real-time inflation, potentially leading to a slight mismatch in protection.
• Taxation on Phantom Income: In some jurisdictions, such as the U.S., the inflation adjustment to the principal is taxable in the year it occurs, even though the investor does not receive this "phantom income" until the bond matures or is sold. This can create a tax liability without a corresponding cash flow, which can be a drawback for investors holding these bonds in taxable accounts.
• Liquidity: While government-issued index linked bonds (like TIPS or gilts) are generally liquid, some corporate or non-government inflation-linked bonds may have lower market liquidity, making them harder to buy or sell quickly without impacting price.

Index Linked Bonds vs. Conventional Bonds

The fundamental difference between index linked bonds and conventional bonds lies in how they address inflation.

The choice between the two depends on an investor's outlook on inflation and their need for purchasing power protection. Those concerned about rising prices or seeking to lock in a specific real return often prefer index linked bonds, while investors who anticipate stable or declining inflation, or who prioritize higher nominal yields, might opt for conventional bonds.

FAQs

1. How do index linked bonds protect against inflation?

Index linked bonds protect against inflation by adjusting their principal value (and consequently, their interest payments) in line with a recognized inflation index, such as the Consumer Price Index (CPI). This adjustment ensures that the purchasing power of your investment is maintained, as the bond's value grows along with the cost of living.

2. Are index linked bonds risk-free?

No, index linked bonds are not entirely risk-free. While they are generally considered low-risk because government-issued ones are backed by the full faith and credit of the issuing government, they still carry interest rate risk (their market price can fluctuate with changes in real interest rates) and potentially liquidity risk for less common issues. They protect against inflation but not necessarily against all forms of market risk.

3. Do index linked bonds always pay more interest than conventional bonds?

Not necessarily. Index linked bonds typically have a lower fixed coupon rate compared to conventional bonds of similar maturity because the inflation protection is already built-in. While their interest payments increase with inflation, their initial nominal payments are often lower, and their total return might be lower than conventional bonds if inflation remains low or turns negative.

4. What happens to index linked bonds during deflation?

During periods of deflation, the principal value of an index linked bond will decrease. However, for most government-issued index linked bonds, there is a principal guarantee: at maturity, investors will receive at least the original principal amount, even if the adjusted principal value is lower due to deflation. The interest payments, however, will be based on the lower, adjusted principal.

5. Can I lose money with index linked bonds?

Yes, it is possible to lose money if you sell an index linked bond before maturity, especially if real interest rates have risen, causing the bond's market price to fall. While they protect against inflation, their market value can still fluctuate. However, if held to maturity, and assuming no default by the issuer, the principal protection feature typically ensures you receive at least your original principal amount.