By Konstantin Vasilev Member of the Board of Directors of Cbonds, Ph.D. in Economics
Updated October 23, 2023
What Are Indexed Bonds?
Indexed bonds, also known as inflation-linked bonds or inflation-indexed securities, are a type of fixed-income investment instrument designed to protect against the eroding effects of inflation. These bonds are often issued by government entities, including the United States Treasury, and are sometimes referred to as Treasury Inflation-Protected Securities (TIPS).
Indexed bonds differ from traditional fixed-interest bonds in that their principal value and interest payments are adjusted for changes in the rate of inflation. In other words, they are linked to a specific inflation index, such as the Consumer Price Index (CPI), which measures the general price level of goods and services in an economy.
The primary purpose of indexed bonds is to protect investors from the negative impact of rising inflation. As the inflation rate increases, the principal value of these bonds is adjusted upward, ensuring that investors’ purchasing power remains relatively stable. Additionally, the interest payments on indexed bonds increase with inflation, allowing investors to earn real interest rates that takes inflation into account. This feature makes indexed bonds an attractive choice for conservative investors who want to protect their investments from the erosion of inflation.
The Origins and Development of Indexed Bonds
Indexed bonds, also known as inflation-linked bonds, have a fascinating history that dates back to the American Revolution. The concept of these bonds was born out of the necessity to combat the corrosive effects of inflation on the real value of consumer goods. While the Massachusetts government is credited with issuing inflation-indexed bonds as early as 1780, it’s worth noting that during this time, inflation indexing seemed unnecessary for established countries that adhered to the gold standard.
Fast forward to the 1970s, and most of the world had abandoned the gold standard. As a result, rising inflation levels created a newfound demand for inflation-linked bonds. In 1981, the United Kingdom became a pioneer in this field by introducing the first modern inflation-linked bonds, often referred to as "linkers."
This groundbreaking development didn’t stop with the UK. Other countries across the globe, including Sweden, Canada, and Australia, recognized the advantages of inflation-linked bonds and followed suit. The United States Treasury, however, didn’t issue inflation-indexed bonds until 1997, somewhat later in comparison to other countries. It’s also noteworthy that India joined the ranks of countries issuing capital-indexed bonds in the same year as the United States.
While India was an early adopter of indexed bonds, it wasn’t until 2013 that the country took the critical step of issuing fully inflation-indexed bonds, which offer comprehensive inflation protection to both the coupon payments and principal value against the erosive effects.
How Indexed Bonds Work
Indexed bonds, also known as inflation-linked bonds, operate based on a unique mechanism that distinguishes them from traditional fixed-income securities. These bonds are tied to the costs of consumer goods, as measured by a designated inflation index, with each country utilizing its own method of calculating these costs periodically. Furthermore, each nation typically has a specific agency responsible for issuing and managing its inflation-linked bonds.
For example, in the United States, Treasury Inflation-Protected Securities (TIPS) and inflation-indexed savings bonds (I bonds) are linked to the value of the U.S. Consumer Price Index (CPI) and are issued by the U.S. Treasury. These bonds provide American investors with a means to protect their investments from the erosive effects of inflation, ensuring that they maintain their purchasing power.
In the United Kingdom, a similar scheme is in place. Inflation-linked gilts are issued by the U.K. Debt Management Office and are tied to that country’s Retail Price Index (RPI). This approach allows British investors to safeguard their investments against the eroding effects of rising prices.
Canada has its own counterpart to indexed bonds, known as real return bonds, issued by the Bank of Canada. These bonds are designed to provide Canadian investors with an investment option that is adjusted for inflation.
In India, the Reserve Bank of India (RBI) takes charge of issuing inflation-indexed bonds. These bonds aim to provide Indian investors with an effective means of protecting their investments from the corrosive effects of inflation.
One of the key features of indexed bonds is the way their outstanding principal is adjusted in response to changes in the rate of inflation. When inflation occurs, the face or par value of these bonds increases. This starkly contrasts traditional securities, which often decrease in value when inflation rises. By indexing the principal value to inflation, indexed bonds provide a hedge against the loss of purchasing power and effectively protect investors from the adverse impacts of inflation. This unique mechanism ensures that investors who hold these bonds see their investments maintain their real value over time.
Benefits and Drawbacks of Indexed Bonds
Benefits
Fixed Long-Term Yield. One of the primary benefits of investing in inflation-indexed bonds is the assurance of a fixed, long-term yield. This appeals to investors seeking stability in their fixed-income investments, especially those concerned about the potential impact of inflation. This means you can count on a predictable return on your investment.
Zero Inflation Risk. Inflation-indexed bonds are designed to protect investors against the erosion of their investment’s real value due to rising prices. They have zero inflation risk, ensuring that your investment maintains its purchasing power even in the face of increasing inflation rates. This is in stark contrast to traditional bonds, which can lose value in real terms when the actual inflation rate rises.
Returns Independent of the Stock Market. Indexed bonds offer returns that are not linked to the performance of the stock market. This characteristic makes them an attractive choice for those seeking to hedge against inflation and diversify their investment portfolio. They provide a reliable source of income that is not subject to the fluctuations of the stock market.
Insights Into Inflation Expectations. Typically, comparing the yields of inflation index-linked bonds to those of nominal fixed-income securities with corresponding maturities can offer valuable insights into inflation expectations within the economy.
Drawbacks
Less Earning Potential. While inflation-indexed bonds provide stability, they may offer less earning potential compared to other investment options, such as stocks. These bonds provide a fixed return, which can be lower than the potential returns offered by other securities. In cases of low inflation rates, the returns on indexed bonds may not be as lucrative as those from alternative investments.
Imperfect Measure of Inflation. In the United States, the most common measure of inflation for inflation-indexed bonds is the Consumer Price Index (CPI). However, some experts argue that the CPI is not a perfect metric for measuring inflation accurately. There is some uncertainty regarding how well indexed bonds will truly protect your investment from the effects of rising prices.
Phantom Income. In the U.S., "phantom income" refers to unrealized gains on investments that are not subject to current taxes. With inflation-indexed bonds, this can occur when the CPI rises, causing the value of your bond to increase. While this may seem advantageous, it’s essential to remember that taxes may be incurred on these unrealized gains, affecting the overall return on your investment.
How to Invest in Indexed Bonds
Investing in indexed bonds, such as inflation-indexed bonds, can be done through several avenues, with two of the most common options being Treasury Inflation-Protected Securities (TIPS) and index funds or exchange-traded funds (ETFs). Here’s how to invest in indexed bonds:
Treasury Inflation-Protected Securities (TIPS)
TIPS are among the most well-known inflation-indexed bonds in the United States. These securities offer a unique feature in that the principal value can change over the bond’s term, and it’s adjusted based on the Consumer Price Index (CPI).
Maturity and Principal Adjustment. When a TIPS matures and the principal value is higher than the original amount, investors receive the increased amount. However, if the TIPS’ principal value is equal to or lower than the initial amount, you will receive the original principal value.
Interest Payments. TIPS provide a fixed rate of interest that is paid every six months until the bond matures. The terms for TIPS typically range from five to 30 years.
Purchasing TIPS. You can purchase TIPS directly from the U.S. Treasury through the TreasuryDirect website. This platform allows you to buy and manage your TIPS investments easily.
Index Funds and ETFs
Investors who prefer not to purchase individual securities can consider investing in indexed bonds through index funds or exchange-traded funds (ETFs). These options allow you to access a diversified portfolio of inflation-indexed bonds without managing individual bonds:
Inflation-Indexed Funds. These funds are designed to track specific indices, such as the Bloomberg World Government Inflation-Linked Bond Index. By investing in these funds, you gain exposure to a broad range of inflation-indexed bonds, diversifying your investment and spreading risk.
Exchange-Traded Funds (ETFs). ETFs offer a similar opportunity to invest in a diversified portfolio of inflation-indexed bonds. ETFs can be bought and sold like stocks on major stock exchanges, providing liquidity and flexibility to investors.
To invest in indexed bonds through index funds or ETFs, you can open a brokerage account with a reputable brokerage firm. Once your account is set up, you can search for the specific index fund or ETF that aligns with your investment goals and risk tolerance. Investing in index funds or ETFs can be an efficient way to access indexed bonds and build a diversified portfolio.
Example of an Index-Linked Bond
Consider two investors—one purchases a regular bond, and another buys an index-linked bond. Both bonds are issued and purchased for $100 during July 2019, with the same terms—a 4% nominal interest rate, 1 year to maturity, and a $100 face value. The Consumer Price Index (CPI) level at the time of issuance is 204.
Regular Bond. The regular bond pays fixed interest rate of 4%, which is $4 ($100 x 4%). The principal amount of $100 is repaid at maturity. So, at maturity, the bondholder receives the principal and the interest payment, totaling $104 ($100 + $4).
Index-Linked Bond. The index-linked bond is different. Assuming the CPI level in July 2020 is 207, both the interest and principal value must be adjusted for inflation.
Calculate the Indexation Factor. The indexation factor is determined by dividing the CPI value for the given date by the CPI at the original issue date of the bond. In this case, the indexation factor is 1.0147 (207/204), indicating a 1.47% inflation rate.
Calculate the Inflation-Adjusted Principal. The inflation-adjusted principal is determined by multiplying the original principal value ($100) by the indexation factor (1.0147), resulting in $101.47.
Calculate the Interest Payment. The coupon payments are calculated using the inflation-adjusted principal amount. In this case, the coupon payment is 4% of the inflation-adjusted principal, which is $4.06.
Calculate the Total Value at Maturity. The bondholder will receive the inflation-adjusted principal ($101.47) and the interest payment ($4.06) when the bond matures. This amounts to $105.53 ($101.47 + $4.06).
Calculate the Annual Interest Rate. The annual interest rate on the bond is 5.53%, calculated as the percentage increase in value from the original principal ($100) to the total value at maturity ($105.53): [(($105.53 - $100)/$100) x 100%].
Calculate the Approximate Real Return Rate. The investor’s approximate real return rate is 4.06% (5.53% - 1.47%), calculated as the nominal rate less the inflation rate.
