What Is an Index-Linked Bond?

What Is an Index-Linked Bond?

Let me explain what an index-linked bond is directly to you. It's a type of bond where the interest payments on the principal are tied to a specific price index, typically the Consumer Price Index (CPI). This setup protects you as an investor by guarding against shifts in that index. The bond's cash flows get adjusted so you receive a predictable real rate of return. You might know it as a real return bond in Canada, Treasury Inflation-Protected Securities (TIPS) in the U.S., or a linker in the U.K.

Key Takeaways

Index-linked bonds, which you may recognize as TIPS in the U.S., pay interest that's connected to an underlying index like the CPI. Governments issue these to counter inflation's effects, delivering a real yield along with any built-up inflation. As an investor, you'll find these bonds advantageous because they're less volatile than standard bonds, and they cut down on the risks tied to uncertainty.

How an Index-Linked Bond Works

Imagine you're a bond investor holding one with a fixed interest rate. Those interest payments, or coupons, usually come semi-annually and represent your return. But over time, inflation rises and eats away at that return's value. This differs from equities or property, where dividends or rents can rise with inflation. That's why governments issue index-linked bonds to soften inflation's blow.

In practice, an index-linked bond adjusts its coupon payments for inflation by linking them to an indicator like the CPI or Retail Price Index (RPI). These investments pay you a real yield plus any accrued inflation, acting as a solid hedge. Everything from yield to payments to principal is figured in real terms, not nominal. Think of the CPI as the conversion rate that turns your bond's return into a real one.

These bonds are particularly useful because their real value is clear from the start, eliminating uncertainty risks. They're also steadier than nominal bonds and help you keep your purchasing power intact.

Important Note

Remember, index-linked bonds deliver a real yield plus inflation, with all calculations—yield, payment, principal—done in real terms, not nominal.

Example of an Index-Linked Bond

Let's walk through an example to make this clear. Suppose two investors: one buys a regular bond, the other an index-linked bond. Both are issued and bought for $100 in July 2019, with identical terms—a 4% coupon rate, one year to maturity, and $100 face value. The CPI at issuance is 204.

The regular bond pays 4% annual interest, or $4 ($100 x 4%), and returns the $100 principal at maturity. So at the end, you get $104 ($100 + $4).

Now, assume the CPI in July 2020 is 207. For the index-linked bond, we adjust interest and principal for inflation using an indexation factor. That's the CPI at the date divided by the CPI at issuance, so 207/204 = 1.0147. This means a 1.47% inflation rate. The bondholder receives $105.53 ($104 x 1.0147) at maturity.

The annual interest rate effectively becomes 5.53% [(($105.53 - $100)/$100) x 100%]. Your approximate real return is 4.06% (5.53% - 1.47%), which is the nominal rate minus inflation.