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.[1] 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.[2] The inflation-linked market primarily consists of sovereign bonds, with privately issued inflation-linked bonds constituting a small portion of the market.
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Inflation-indexed bonds pay a periodic coupon that is equal to the product of the inflation index and the nominal 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.
For some bonds, such as the Series I Savings Bonds (U.S.), the interest rate is adjusted according to inflation.
For other bonds, such as in the case of TIPS, the underlying principal of the bond changes, which results in a higher interest payment when multiplied by the same rate. For example, if the annual coupon of the bond were 5% and the underlying principal of the bond were 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 real yield of a TIPS bond represents the annualized growth rate of purchasing power earned by holding the security to maturity. Real yield can be calculated easily on a standard bond calculator or spread sheet by entering the TIPS quoted market price,coupon rate, and maturity date. The calculator does not know the bond is a TIPS or that the price and coupon rate are real. It is the user’s responsibility to interpret the result as the “real yield.”
The real yield of a nominal bond is more difficult to calculate because it can be precisely determined only with the benefit of hindsight. In practice, when analysts speak of a nominal bond’s real yield, they may be (1) referring to its “current” real yield (approximated by subtracting the current year-over-year inflation from the bond’s nominal yield), (2) “guesstimating” the nominal bond’s “expected” real yield based on expectations of future inflation, or (3) speaking of historical realized real yields on bonds that have matured.
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, Australia, Italy, Japan, Sweden and Iceland also issue inflation-indexed bonds, as well as a number of Emerging Markets, most prominently Brazil.[3] [4]
| Country | Issue | Issuer | Inflation Index |
|---|---|---|---|
| United States | Treasury Inflation-Protected Securities (TIPS)[5] | US Treasury | US Consumer Price Index |
| United States | Series I Inflation-Indexed Savings Bonds (I-Bonds - domestic retail bonds)[6] | US Treasury | US Consumer Price Index |
| United Kingdom | Index-linked Gilt | UK Debt Management Office | Retail Price Index (RPI) |
| United Kingdom | Index-linked Savings Certificates (domestic retail bonds) | National Savings and Investments | Retail Price Index (RPI) |
| France | OATi and OAT€i[7] | Agence France Trésor | France CPI ex-tobacco (OATi), EU HICP ex-tobacco (OAT€i) |
| Canada | Real Return Bond (RRB)[8] | Bank of Canada | Canada All-Items CPI |
| Australia | Capital Indexed Bonds (CAIN series) | Department of the Treasury (Australia) | Weighted Average of Eight Capital Cities: All-Groups Index |
| Germany | Bund index. and BO index. | Bundesrepublik Deutschland Finanzagentur | EU HICP ex Tobacco |
| Greece | EU HICP ex Tobacco | ||
| Hong Kong | iBond (domestic retail bonds) | Hong Kong Government | Composite Consumer Price Index |
| Italy | BTP€i | Department of the Treasury | EU HICP ex Tobacco |
| Japan | JGBi | Ministry of Finance (Japan) | Japan CPI (nationwide, ex-fresh-food) |
| Sweden | Index-linked treasury bonds | Swedish National Debt Office | Swedish CPI |
| Iceland |
Inflation-indexed bond indices include the family of Barclays Inflation Linked Bond Indices,[9] such as the Barclays Inflation Linked Euro Government Bond Indices, and the Lehman Brothers U.S. Treasury: U.S. TIPS index.[10]
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