Indexed Bonds: Meaning
A bond that releases interest payments on the basis of a particular price index is known as Indexed Bonds or Index-Linked Bonds, or Inflation-Indexed Bonds. The Central Government of the country mostly issues this type of Bond, which are mostly for the medium term or long term. Although, State Government or Corporations also issues Indexed-Linked Bonds these days. Under Index-Linked Bonds, the benchmark price index taken into consideration for calculating all interest payments is mostly Consumer Price Index (CPI) or Retail Price Index (RPI). The selection of benchmark takes place in accordance with the inflation effect on the investment. The investors get a real interest rate under this Bond investment.
The coupon rate for interest remains fixed in Indexed-Linked Bonds. And interest payments happen mostly on a semi-annual basis. While calculating returns/interest on payment dates on these Bonds, inflation-adjusted principal value is taken into consideration. The indexation factor (also known as the Index Ratio) is useful for calculating inflation-adjusted principal value.
Indexation Factor = Current Consumer Price Index (CPI)/ Consumer Price Index (CPI) at the time of issuance
Indexed Bonds have different names in different countries like in Canada, they are known as Real Return Bonds; in the United Kingdom, they are known as Linker, and in the United States of America, they are issued as TIPS (Treasury Inflation-Protected Securities) or Inflation-Indexed Savings Bonds (I-Bonds).
Examples of Indexed Bonds
Let’s understand Indexed Bond with a few hypothetical examples:-
Suppose ADS Bonds are issued at face value of $1000, with a coupon rate of 8% and a maturity of 1 year. Moreover, the payment of interest will happen on maturity together with the Principal amount. Further, assume The Consumer Price Index at the time of Issuance is 155. At the same time, the Consumer Price Index at the time of maturity is 160.
Also Read: Plain Vanilla Bonds
Indexation Factor = 160/155 = 1.032
Inflation Rate = (160-155)/ 155 * 100
At the time of maturity, the principal and interest repayment would be $1080 (1000 + 1000* 0.08).
The repayment value after considering inflation will be as follows:-
1080 * 1.032 = $1114.56
Thus, the total payment on maturity would be $1114.56. This amount consists of the Original Principal: $1000; Interest at a Coupon Rate of 8% of $80, and the inflation factor of $34.56 (1000+80+34.56).
In the above example,
The nominal Annual Interest Rate (AIR) = (1114.56- 1000)/1000 * 100
Annual Interest Rate = 11.456%
Real Interest Rate = 11.456% – 3.22% (inflation) =
Real Interest Rate = 8.23%
Keeping all things constant, as in Example 1, the only difference is that the Consumer Price Index (CPI) at the time of maturity is 156.
Indexation Factor = 156/155 = 1.006
Inflation Rate = 0.645%
Total repayment amount at the time of maturity = 1.006 * 1080 = $1086.48
Thus $1086.48 would be repaid at the time of maturity.
Annual Interest Rate (AIR) = (1086.48 – 1000)/1000 * 100
Annual Interest Rate (AIR) = 8.648%
Real Interest Rate = 8.648 – 0.645
Real Interest Rate = 8.003%
Advantages of Indexed Bonds
- Indexed Bond provide inflation-adjusted returns to the investors, i.e., it provides real interest rates and protects from the effects of inflation.
- These Bonds generally yield higher returns in comparison to other types of Bonds.
- Indexed Bonds, in comparison to other types of Bonds, are less volatile and less risky.
- As Government issues these types of Bonds, they are more authentic and risk-free in nature.
- Indexed-Linked Bonds act as one of the major sources of finance for the Government.
- These bonds boost the infrastructural projects of the Government, thereby enhancing growth in the country. They also boost the savings rate in the country by enhancing savings in the economy.
- Nationally recognized inflation indicators are in direct link with the Indexed Bonds; as a result, it hedges directly with the current price level in the economy.
- Sometimes, the Government issues these bonds to redistribute wealth in the economy and save the middle class, retired or dependent people from the inflation effect.
- Investors receive inflationary adjusted fixed coupon rate and principal at the time of maturity.
- Indexed Bond allows premature redemptions but does not give any additional tax benefit.
- At the time of deflation, the investors, most of the time, at least receive the face value of their investment. Generally, returns do not go below that level.
- A zero correlation exists between the returns of any fixed-income security or stocks with the Indexed Bonds. This makes it unique.
- Indexed Bonds are also useful as a diversification tool for the portfolio managers while managing the portfolios.
These advantages are non-exhaustive in nature.
Indexed Bond Vs. Fixed Deposit
There are many differences between Indexed Bond and Fixed deposits. When Inflation takes place in the economy, Indexed-Linked Bond releases higher returns. While, at the time of inflation in the economy, Fixed Deposit releases fixed returns. The real value of returns diminishes in the case of Fixed Deposits.
Indexed-Linked Bond, in comparison to Fixed Deposit, is more liquid in nature. Mostly, Fixed Deposits do not have any secondary market for trading. Indexed-Linked Bond is tradable in nature.
These differences are non-exhaustive in nature.
According to a few critics, there exist a few limitations of Index-Linked Bonds. Irrespective of this, it is one of the most trusted investment instruments which gives real interest rates to the investors. The advantages have far outweighed the criticisms, and Indexed-Linked Bonds play a very important role in the economy. It helps in keeping the functioning of the Capital Market and Money Market in line. Indexed-Linked Bonds save the citizens of the country from the inflation effect and help their investment grow.
Read about other Different Types of Bonds.