Everything about Inflation-indexed Bond totally explained
Inflation-indexed bonds (also known as
inflation-linked bonds or colloquially as
linkers) are
bonds where the principal is indexed to
inflation. They are thus designed to cut out the inflation risk of an investment.. 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. As of 2008, government-issued inflation-linked bonds comprise over $1.5 trillion of the international debt market. The inflation-linked market primarily consists of sovereign debt, with privately issued inflation-linked bonds constituting a small portion of the market.
Structure
Inflation-indexed bonds pay a
coupon that's equivalent to the sum of the increase in an inflation index and the real coupon rate. The relationship between coupon payments, breakeven inflation and real interest rates is given by the
Fisher equation. A rise in coupon payments is a result of an increase in inflation expectations, real rates, or both.
A common misconception about these bonds is that the interest rate changes with inflation. What actually happens is that the underlying of the bond changes, which results in a higher
interest payment when multiplied by the same rate. For example, if the coupon of an annual bond was 5% and the underlying principal of the bond was 100 units, the annual payment would be 5 units. If the inflation index increased by 10%, the principal of the bond would increase to 110 units. The coupon rate would remain at 5%, resulting in an interest payment of 110 x 5% = 5.5 units. The only known exception to this is the Australian
Capital Indexed Bond, in which the interest rate is adjusted as well as the principal.
Global issuance
The most liquid instruments are
Treasury Inflation-Protected Securities (TIPS), a type of
US Treasury security, with about $500 billion in issuance. The other important inflation-linked markets are the UK Index-linked Gilts with over $300 billion outstanding and the French OATi/OAT€i market with about $200 billion outstanding.
Germany,
Canada,
Greece,
Italy,
Japan,
Sweden and
Iceland - as well as a number of smaller emerging markets - also issue inflation-indexed bonds; the
Australian government stopped issuing the Capital Indexed Bond in
2003
Inflation-indexed bond indices
Inflation-indexed
bond indices include Barclays World Government Inflation-Linked Index.
Further Information
Get more info on 'Inflation-indexed Bond'.
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