Index-Linked Bond

What Is an Index-Linked Bond?

An index-linked bond is a bond where payment of interest income on the principal is connected with a specific price index, generally the Consumer Price Index (CPI). This feature gives protection to investors by safeguarding them from changes in the underlying index. The bond's cash flows are adjusted to guarantee that the holder of the bond receives a known real rate of return. An index-linked bond is otherwise called a real return bond in Canada, Treasury Inflation-Protected Securities (TIPS) in the U.S., and a linker in the U.K.

How an Index-Linked Bond Works

A bond investor holds a bond with a fixed interest rate. The interest payments, known as coupons, are normally paid semi-annually and address the bondholder's return on investing in the bond. In any case, as time passes by, inflation additionally increases, accordingly, eroding the value of the investor's annual return. This is not normal for returns on equity and property, in which dividend and rental income increase with inflation. To relieve the impact of inflation, index-linked bonds are issued by the government.

An index-linked bond is a bond which has its coupon payments adjusted for inflation by connecting the payments to some inflation indicator, for example, the Consumer Price Index (CPI) or Retail Price Index (RPI). These interest-bearing investments ordinarily pay investors a real yield plus accrued inflation, giving a hedge against inflation. The yield, payment, and principal amount are calculated in real terms, not nominal numbers. One can think of the CPI as the exchange rate that switches the return on a bond investment over completely to a real return.

An indexed-linked bond is important to investors on the grounds that the real value of the bond is known from purchase and the risk implied with vulnerability is disposed of. These bonds are additionally less unpredictable than nominal bonds and assist investors with keeping up with their purchasing power.

Index-linked bonds give a real yield plus inflation, with all that — yield, payment, principal — calculated in real terms, not nominal.

Illustration of an Index-Linked Bond

Think about two investors — one purchases an ordinary bond and another purchases an index-linked bond. The two bonds are issued and purchased for $100 during July 2019, having similar terms — 4% coupon rate, 1 year to maturity, and $100 face value. The CPI level at the hour of issuance is 204.

The standard bond pays an annual interest of 4%, or $4 ($100 x 4%), and the principal amount of $100 is repaid at maturity. At maturity, the principal and the interest payment due, or at least, $100 + $4 = $104, will be credited to the bondholder.

Accepting the CPI level in July 2020 is 207, the interest and principal value must be adjusted for inflation with the index-linked bond. Coupon payments are calculated utilizing an inflation-adjusted principal amount, and a indexation factor is utilized to decide the inflation-adjusted principal amount. For a given date, the indexation factor is defined as the CPI value for the given date partitioned by the CPI at the original issue date of the bond. The indexation factor in our model is 1.0147 (207/204). Subsequently, the inflation rate is 1.47%, and the bondholder will receive $105.53 ($104 x 1.0147) when it develops.

The annual interest rate on the bond is 5.53% [(($105.53 - $100)/$100) x 100%]. The investor's rough real return rate is 4.06% (5.53% - 1.47%), calculated as the nominal rate less the inflation rate.

Features

• These bonds are beneficial to investors since they are less unpredictable than normal bonds and the risk implied with vulnerability is diminished.
• Index-linked bonds — additionally called Treasury Inflation-Protected Securities in the U.S. — pay interest that is linked to an underlying index, for example, the Consumer Price Index (CPI).
• Index-linked bonds are issued by governments to assist with relieving the impact of inflation, paying a real yield plus accrued inflation.