Index-Linked Bond

Index-Linked Bond

An index-linked bond is a bond in which payment of interest income on the principal is related to a specific price index, usually the Consumer Price Index (CPI). Index-linked bonds — also called Treasury Inflation-Protected Securities in the U.S. — pay interest that is linked to an underlying index, such as the Consumer Price Index (CPI). Index-linked bonds are issued by governments to help mitigate the impact of inflation, paying a real yield plus accrued inflation. An index-linked bond is a bond which has its coupon payments adjusted for inflation by linking the payments to some inflation indicator, such as the Consumer Price Index (CPI) or Retail Price Index (RPI). An index-linked bond is a bond in which payment of interest income on the principal is related to a specific price index, usually the Consumer Price Index (CPI). Index-linked bonds provide a real yield plus inflation, with everything — yield, payment, principal — calculated in real terms, not nominal.

Index-linked bonds — also called Treasury Inflation-Protected Securities in the U.S. — pay interest that is linked to an underlying index, such as the Consumer Price Index (CPI).

What Is an Index-Linked Bond?

An index-linked bond is a bond in which payment of interest income on the principal is related to a specific price index, usually the Consumer Price Index (CPI). This feature provides protection to investors by shielding them from changes in the underlying index. The bond's cash flows are adjusted to ensure that the holder of the bond receives a known real rate of return. An index-linked bond is also known as a real return bond in Canada, Treasury Inflation-Protected Securities (TIPS) in the U.S., and a linker in the U.K.

Index-linked bonds — also called Treasury Inflation-Protected Securities in the U.S. — pay interest that is linked to an underlying index, such as the Consumer Price Index (CPI).
Index-linked bonds are issued by governments to help mitigate the impact of inflation, paying a real yield plus accrued inflation.
These bonds are beneficial to investors because they are less volatile than normal bonds and the risk involved with uncertainty is reduced.

How an Index-Linked Bond Works

A bond investor holds a bond with a fixed interest rate. The interest payments, known as coupons, are usually paid semi-annually and represent the bondholder’s return on investing in the bond. However, as time goes by, inflation also increases, thereby, eroding the value of the investor’s annual return. This is unlike returns on equity and property, in which dividend and rental income increase with inflation. To mitigate 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 linking the payments to some inflation indicator, such as the Consumer Price Index (CPI) or Retail Price Index (RPI). These interest-bearing investments typically pay investors a real yield plus accrued inflation, providing 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 converts the return on a bond investment to a real return.

An indexed-linked bond is valuable to investors because the real value of the bond is known from purchase and the risk involved with uncertainty is eliminated. These bonds are also less volatile than nominal bonds and help investors maintain their purchasing power.

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

Example of an Index-Linked Bond

Consider two investors — one purchases a regular bond and another buys an index-linked bond. Both bonds are issued and purchased for $100 during July 2019, having the same terms — 4% coupon rate, 1 year to maturity, and $100 face value. The CPI level at the time of issuance is 204.

The regular 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, that is, $100 + $4 = $104, will be credited to the bondholder.

Assuming 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 using an inflation-adjusted principal amount, and an indexation factor is used to determine the inflation-adjusted principal amount. For a given date, the indexation factor is defined as the CPI value for the given date divided by the CPI at the original issue date of the bond. The indexation factor in our example is 1.0147 (207/204). Therefore, the inflation rate is 1.47%, and the bondholder will receive $105.53 ($104 x 1.0147) when it matures.

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

Related terms:

30-Year Treasury

The 30-Year Treasury, formerly the bellwether U.S. bond, is a U.S. Treasury debt obligation that has a maturity of 30 years. read more

Consumer Price Index (CPI)

The Consumer Price Index (CPI) measures the average change in prices over time that consumers pay for a basket of goods and services. read more

Coupon

A coupon is the annual interest rate paid on a bond, expressed as a percentage of the face value, also referred to as the "coupon rate." read more

Fixed Income & Examples

Fixed income refers to assets and securities that bear fixed cash flows for investors, such as fixed rate interest or dividends. read more

Indexation

Indexation is a method of linking the price or value of an asset to a price or price index of some type to adjust for inflation. read more

Inflation-Indexed Security

An inflation-indexed security is a security that guarantees a return higher than the rate of inflation if it is held to maturity. Inflation-indexed securities link their capital appreciation, or coupon payments, to inflation rates. read more

Inflation

Inflation is a decrease in the purchasing power of money, reflected in a general increase in the prices of goods and services in an economy. read more

Maturity

Maturity refers to a finite time period at the end of which the financial instrument will cease to exist and the principal is repaid with interest.  read more

Municipal Inflation-Linked Securities

Municipal inflation-linked securities are investment vehicles where the variable coupon payments are indexed to the current inflation rate. read more

Nominal Yield

A bond's nominal yield, depicted as a percentage, is calculated by dividing all the annual interest payments by the face value of the bond. read more