Fixed-Income Types: Index-Linked Bonds

Sometimes it seems like Dr. Frankenstein works in the creation of fixed-income securities. The breadth of bond types is astounding, and just one small category of bonds with a list of its own variants is that of __index-linked bonds__. The idea is simple enough: the bond is linked to an index. But there are many types of established, published indexes, including commodities indexes, equity indexes, inflation indexes, macroeconomic indexes, etc. Any combination is possible.

One popular subset of index-linked bonds is the family of __inflation-linked bonds__. These bonds have a reference index, such as the consumer price index (CPI) for the US, and the cash flows of the bond are somehow tied directly to that index. Since inflation erodes purchasing power of currency, it also erodes the purchasing power of a bond's future cash flows. So it makes sense that investors might be interested in a bond that has some link with an inflation index.

What do you think an investor of a 1,000 year inflation-linked bond (so pretty much a perpetuity) hopes will happen to inflation after the bond is purchased?

No. If inflation rises, the investor will get paid a larger amount of currency. Think about how inflation itself will reduce the value of that currency.

No. If inflation falls, the money received by the investor will be worth more than expected. But at the same time, consider that the inflation link will ensure that the investor receives less money.

Exactly! It really shouldn't matter. If inflation rises, the investor will get more money that is worth a little less per unit. If inflation falls, the investor gets less money that is worth a little more per unit. Either way, the purchasing power should be about the same, which is the point of an inflation-linked bond.

Governments issue a large number of these inflation-linked bonds, which are also called "linkers." Nominal interest rates are the interest rates actually paid and received, and inflation is the portion of these interest rates which is not "real." So the real interest rate is close to the nominal rate minus inflation.

Suppose that the sovereign nation of Ayowya issues a bond that pays a coupon of 4.3%, and that coupon is linked to an inflation measurement index which is currently 1.2%. What do you think the nominal and real coupon rate would be after this inflation index rises to 1.8%?

No. With a positive inflation rate, the nominal rate is always greater than the real rate.

That's right! Since inflation increased 0.6%, the linked coupon should also increase 0.6%, from 4.3% to 4.9%. The real return on these coupons was the 4.3% nominal rate minus the 1.2% inflation rate for a real rate of 4.3% - 1.2% = 3.1%. After the increase in inflation, the real return is the new nominal rate of 4.9% minus the new inflation rate of 1.8% for a real rate of 4.9% - 1.8% = 3.1%. So the real rate paid to investors didn't change, and that's really the point of an inflation-linked bond. Investors count on having a set real rate of return from their investment.

No. Think about the fact that the difference between a nominal rate of return and a real rate of return is the inflation measure, which has now increased.

So one choice for Ayowya is to issue __interest-indexed bonds__. These bonds would pay a coupon, and that coupon would be what changes with the price level. Suppose they offered a 10% coupon, paying AYO 100 each year on each bond. If the 12% price level increase occurs, then these coupon payments will adjust to AYO 100(1 + 12%) = AYO 112 per year.

How would this sound to you if this happened, and you owned an Ayowya bond?

No, they fooled you. You didn't get the inflation protection you thought you would.

Good observation!

So if investors are too clever for this, then perhaps a __capital-indexed bond__ is a better choice. Starting with the same 10% coupon bond, a capital-indexed bond would increase its coupons by 12%, and its face value by 12%. How does this sound to you as an investor?

It is, yes.

No, it's a fair deal.

To summarize this discussion: [[summary]]

The coupons adjusted, sure. But that's not enough. There's still that large AYO 1,000 face value, and it's still AYO 1,000, even though the new price level makes it worth less in real terms. This bond definitely did not hold its value.

Since all of the bonds' cash flows increased 12%, they are all worth exactly the same in real terms as they were before the price level change. No real benefit or loss. __Treasury inflation-protected securities (TIPS)__ is an example of a capital indexed bond, that offers this real protection of both principal and coupons. They are quite popular. Now even some corporations issue such instruments. So Ayowya has several choices as to how to entice investors into funding its deficits. But the government better hope it can get ahead of its spending. If all that is issued is inflation-indexed debt, then the only way to pay it off is to really pay it off!

That inflation will rise

That inflation will fall

It really shouldn't matter much to the investor

Nominal rate of 4.3% and real rate of 4.9%

Nominal rate of 4.9% and real rate of 3.1%

Nominal rate of 4.9% and real rate of 3.7%

Sounds just fine; the coupons adjusted with the price level

Sounds like a rip-off. The bond is a worse deal after the price level increase

This is a fair deal. The bond's real value wouldn't change

It's still a bad deal after the price level change

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