Explain Inflation-linked Bonds

Inflation-linked bonds are also called index bonds. Their return is usually linked to the CPI (consumer price index) and as such is a variation of floating rate bonds. The differences are that the benchmark is not an interest rate but the inflation rate, and the principal value is adjusted for the differential between the CPI rate and the benchmark rate.

There is no generic CPI bond. The type is found in many countries (which are usually issued by government and parastatals – public enterprises) can be described as follows: the coupon rate is determined in an open market auction and remains fixed throughout the life of the bond. Adjustments are made to the bond’s capital value to compensate for inflation.

An example is required. If the coupon on the bond is 6.0% pa and the investment is LCC1 million, the interest paid per annum is LCC60 000. If inflation in the next year is 4.0% pa, the capital value of the bond is adjusted to LCC1 040 000 (LCC1 000 000 x 1.04). The coupon rate of 6.0% pa remains unchanged but is payable on the higher capital value; it is therefore LCC62 400 (LCC1 040 000 x 0.06). This means that both capital and income are adjusted upwards by the CPI inflation rate.


Figure: example of inflation-linked bond

Another example is presented in Figure (inflation fluctuates between 5% and 10%; coupon = 12%). Inflation-linked bonds are appropriate for investors who need to match inflation-linked liabilities.