Inflation-indexed bond
Encyclopedia : I : IN : INF : Inflation-indexed bond
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Inflation-indexed bonds (also known as linkers) are bonds whose principal are indexed to inflation, cutting out inflation risk*. The first known inflation-indexed bond was issued by the Massachusetts Bay Company in 1780. The market has grown dramatically since the British government began issuing inflation-linked Gilts in 1981. Today, the asset class comprises over $500 Billion of the international debt market. The market primarily consists of sovereign debt, with privately issued inflation-linked bonds constituting a small portion of the market.
*Unfortunately, income taxes bring some inflation risk back to such bonds. See tax on the inflation tax
Underlying Mechanism
A common misconception about these bonds is that the interest rate changes with inflation. What actually happens is that the underlying [principal] of the bond changes, which results in a higher interest payment when multiplied by the same rate. For example, if the coupon of a bond was 5%, and the underlying principal of the bond was 100 units, the bond would pay 5 units, assuming annual payments. If the inflation index then increased by 10%, the principal of the bond would then increase to 110 units. This is multiplied by the same coupon rate of 5%, which results in an interest payment of 5.5 units. The only known exception to this is the Australian Capital Indexed Bond, which also adjusts the interest rate.Global issuance
Best known in the U.S. are Treasury Inflation-Protected Securities (TIPS), a type of US Treasury security. The U.K. also issues Index-linked Gilts. The Australian government stopped issuing the Capital Indexed Bond in 2003. The Australian bond was unique among inflation-linked bonds in that the rate of interest and the principal were both linked to inflation. France, Canada, Greece, Italy, Japan, and Sweden also issue Inflation Indexed Bonds.External links
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