Inflation Indexed Bonds

10 Key excerpts on "Inflation Indexed Bonds"

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  eBook - ePub

  Demystifying Fixed Income Analytics

  A Practical Guide

  • Kedar Nath Mukherjee(Author)
  • 2020(Publication Date)
  • Routledge India

    (Publisher)

  The principal of these bonds is linked to an accepted index of inflation with a view to protecting the holder from inflation. Inflation Indexed Bonds (IIBs) were issued in India in the name of capital indexed bonds (CIBs) during 1997, providing inflation protection only to principal and not to interest payment. But IIBs are expected to provide inflation protection to both principal and interest payments. With an inflation indexed bond, the real rate of return is known in advance, and the nominal return varies with the rate of inflation realized over the life of the bond. Hence, neither the purchaser nor the issuer faces a risk that an unanticipated increase or decrease in inflation will erode or boost the purchasing power of the bond’s payments. Investors who desire predictable real cash flows can now include indexed bonds in their portfolios. The certain real return will be attractive to investors who are particularly risk averse. It will also be attractive to savers who want to protect their savings from being eroded by inflation. Since inflation-indexed bonds remove the investor’s inflation risk, by issuing indexed bonds, the Treasury can avoid paying the inflation risk premium found in nominal interest rates on conventional bonds and can thereby lower its borrowing costs.

  The inflation component on principal will not be paid with interest but the same would be adjusted in the principal by multiplying the principal with the index ratio (IR), ratio of recent inflation index to the base index. At the time of redemption, the adjusted principal or the face, whichever is higher, would be paid. The interest rate will be provided protection against inflation by paying a fixed coupon rate on the principal adjusted against inflation. The consumer price index (CPI) reflects inflation to the larger extent, and therefore, globally CPI or the retail price index (RPI) is used for IIBs. Since all India CPI has been released since January 2011, and it will take some time to stabilize, it has been decided to consider WPI for inflation protection in IIBs. For example, if the annual coupon is 8% and the principal is Rs.100/-, the investor will be paid Rs.8/- per annum. If the inflation index rises 10%, the principal will become Rs.110/-. The coupon will remain 8%, resulting in an interest payment of Rs.110 x 8 per cent = Rs.8.8/

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  eBook - ePub

  Handbook of Fixed-Income Securities

  • Pietro Veronesi(Author)
  • 2016(Publication Date)
  • Wiley

    (Publisher)

  3 Inflation-Adjusted Bonds and the Inflation Risk Premium Matthias Fleckensteina , Francis Longstaffb and Hanno Lustigc

  a Cornerstone Research, New York, NY, United States

  b Anderson School of Management, UCLA, Los Angeles, CA, United States, ,

  c Graduate School of Business, Stanford University, Stanford California

  3.1 Inflation-Indexed Bonds

  Inflation-indexed bonds differ from standard coupon bonds in that the nominal principal of an inflation-indexed bond is indexed to the price level. Since a fixed coupon rate is applied to the principal that varies with the price level, the actual coupon payments vary in response to the realized rate of inflation or deflation.

  There is a long history of countries issuing inflation-linked debt. Emerging market countries started to issue inflation-linked bonds in the 1950s. Much later, the United Kingdom’s Debt Management Office followed suit with the first inflation-linked gilt issue in 1981, followed by Australia, Canada, and Sweden. The U.S. Treasury only started issuing Treasury Inflation-Protected Securities (TIPS) in 1998. Currently, France, Germany, and Italy are frequent issuers of inflation-linked bonds in the Euro area. Japan recently started issuing inflation-linked bonds again. Australia, Brazil, Canada, Chile, Israel, Mexico, Turkey, and South Africa also issue substantial amounts of inflation-linked bonds.

  Governments have several motives for issuing inflation-linked bonds. First, inflation-linked bonds reduce the effect of inflation on the real debt burden. This provides a commitment technology to those countries who want to signal a strong commitment to low inflation. Second, inflation-linked bonds may provide investors with a new asset whose payoffs are not spanned by existing securities and thus help to complete the market. Long-term real bonds are an important asset for long-term investors (Campbell and Viceira, 2001). Third, the Treasury could reduce its funding cost by not paying the inflation risk premium, provided that the inflation risk premium is positive. Fourth, these securities possibly provide policy makers as well as market participants with new tools for gauging the inflation expectations of investors and forecasting inflation. The latter is notoriously hard to do well out of sample using fundamentals (Atkeson and Ohanian, 2001; Stock and Watson, 2007).

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  Advanced Fixed Income Analysis

  • Moorad Choudhry, Michele Lizzio(Authors)
  • 2004(Publication Date)
  • Butterworth-Heinemann

    (Publisher)

  8 Advanced Analytics for Index-linked Bonds Bonds that have part or all of their cash flows linked to an inflation index form an important segment of several government bond markets. In the United Kingdom the first index-linked bonds were issued in 1981 and at the end of 1999 they accounted for approximately 15% of outstanding nominal value in the gilt market. Index-linked bonds were only recently introduced in the US Treasury market but are more established in Australia, Canada, the Netherlands, New Zealand and Sweden. There is no uniformity in market structure and as such there are sig-nificant differences between the index-linked markets in these countries. There is also a wide variation in the depth and liquidity of these markets. Index-linked bonds or inflation-indexed bonds present additional issues in their analysis, due to the nature of their cash flows. Measuring the return on index-linked bonds is less straightforward than with conventional bonds, and in certain cases there are peculiar market structures that must be taken into account as well. For example, in the US market for index-linked Treasuries (known as ‘TIPS’ from Treasury inflation-indexed securities) there is no significant lag between the inflation link and the cash flow payment date. In the UK there is an eight-month lag between the inflation adjustment of the cash flow and the cash flow payment date itself, while in New Zealand there is a three-month lag. The existence of a lag means that inflation protection is not available in the lag period, and that the return in this period is exposed to inflation risk; it also must be taken into account when analysing the bond. From market observation we know that index-linked bonds can experience considerable volatility in prices, similar to conventional bonds, and therefore there is an element of volatility in the real yield return of these bonds.

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  Inflation-indexed Securities

  Bonds, Swaps and Other Derivatives

  • Mark Deacon, Andrew Derry, Dariush Mirfendereski(Authors)
  • 2004(Publication Date)
  • Wiley

    (Publisher)

  As Section 3.7 discusses, large holdings of indexed bonds by such ‘‘buy-and-hold’’ investors is likely to reduce the liquidity of the secondary market and so reduce the attractiveness of the asset class to investors who value liquidity. Indexed bonds can also appeal to individual investors. In addition to providing an alternative to a standard pension plan, indexed bonds can be used by those preparing for large future capital expenditures (e.g., purchasing a house or sending children to college) for which it is desirable that such savings are not eroded by unexpected inflation. In its marketing programme prior to the launch of its Treasury Inflation- Protection Securities (TIPS) series in 1997, the US Treasury cited this as one of the primary attractions of inflation-indexed securities for individuals. 4 Personal investors certainly form an important part of the UK index-linked gilt market: as of October 2002 there were over 55,000 registered holders of index-linked gilts of which almost 68% could be identified as personal investors, 5 although unsurprisingly this proportion falls below 2% when measured in terms of the nominal value of bondholdings. Bootle (1991) argues that, although indexed bonds are specifically designed to protect investors from increases in the price level, they are at their most useful in situations of moderate to high inflation, since in a hyperinflationary environment the continued integrity of the price indices themselves would probably be in some doubt. Also, in such a climate even a short lag in indexation can leave investors seriously under- compensated. 3.2 RELATIVE STABILITY OF RETURNS In principle, inflation-indexed bonds represent a less risky class of asset than conven- tional bonds or equities, since their real returns are much less affected by unexpected changes in inflation.

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  eBook - ePub

  Accounting for Derivatives

  Advanced Hedging under IFRS 9

  • Juan Ramirez(Author)
  • 2015(Publication Date)
  • Wiley

    (Publisher)

  Assuming an inflation-linked bond (ILB) and a comparable fixed rate bond of the same issuer and liquidity, the BEI equals the difference between the yields of these bonds. If actual inflation is greater than breakeven inflation, the ILB is likely to outperform the fixed rate bond. If actual inflation is lower than breakeven inflation, the fixed rate bond is likely to outperform the ILB. In other words, breakeven inflation is the future inflation rate required for an ILB to achieve the same return as a comparable fixed rate bond, if held to maturity. Thus, investors who wish to take a view on the path of inflation have a choice. If they believe that inflation will be higher than the level priced in by the market, they will sell fixed rate bonds and buy ILBs. If lower, they will do the opposite.

  12.2 INFLATION-LINKED BONDS

  This section discusses the basics of inflation-linked bonds. It explains key concepts such as real rates and breakeven inflation. ILBs, sometimes known as “linkers” or “real bonds”, are an attractive asset class for investors whose liabilities are linked to inflation, such as insurance companies and pension funds. ILBs are predominantly issued by governments and ­provide income and total return which adjusts to keep up with the pace of inflation. The UK was the first major market to issue these bonds in 1981 and the US government followed suit by issuing Treasury inflation-protected securities (TIPS) in 1997. Inflation-indexed government bonds are also available in many other countries including Australia, Canada, France, ­Germany, Italy and Sweden.

  The main cash flows in a ILB are as follows (see Figure 12.3 ):

  • On the issue date, the ILB investors pay the bond's initial notional to the issuer (or to the banks intermediating the issuance).
  • Periodically, the issuer pays to the investors a fixed coupon on an inflation-adjusted notional amount.
  • At maturity, the issuer pays to the investors the initial notional adjusted for inflation.

  Figure 12.3

  Inflation-linked bond cash flows.

  A new ILB is typically issued with an initial notional and a real yield determined through the auction process. Imagine that on 1 January 20X0 a new ILB was issued with a real semiannual coupon of 2%, a initial notional of 100 and a 2-year maturity. The initial consumer price index (Index0 ) was set at 200, the CPI for October 20W9, 3 months prior to the issue date.

  Over time, the notional adjusts according to changes in the CPI from the time the bond is issued. In our example, the adjusted notional amount at time t equalled 100 × Indext /Index0 , where Indext is the value of the CPI at time t

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  Corporate Bonds and Structured Financial Products

  • Moorad Choudhry(Author)
  • 2004(Publication Date)
  • Butterworth-Heinemann

    (Publisher)

  In practice most bonds have been linked to an index of consumer prices such as the UK Retail Price Index, since this is usually widely circulated and well understood and issued on a regular basis. & Indexation lags. In order to construct precise protection against inflation, interest pay-ments for a given period would need to be corrected for actual inflation over the same period. However unavoidable lags between the movements in the price index and the adjustment to the bond cash flows distort the inflation-proofing properties of indexed bonds. The lags arise in two ways. First, inflation statistics can only be calculated and published with a delay. Secondly in some markets the size of the next coupon payment must be known before the start of the coupon period in order to calculate the accrued interest; this leads to a delay equal to the length of time between coupon payments. & Coupon frequency. Index-linked bonds often pay interest on a semi-annual basis. & Indexing the cash flows. There are four basic methods of linking the cash flows from a bond to an inflation index. These are: w Interest-indexed bonds: these pay a fixed real coupon and an indexation of the fixed principal every period; the principal repayment at maturity is not adjusted. In this case all the inflation adjustment is fully paid out as it occurs and does not accrue on the principal. These type of bonds have been issued in Australia, although the most recent issue was in 1987. w Capital-indexed bonds: the coupon rate is specified in real terms. Interest payments equal the coupon rate multiplied by the inflation-adjusted principal amount. At maturity the principal repayment is the product of the nominal value of the bond multiplied by the cumulative change in the index. Compared with interest-indexed bonds of similar maturity, these bonds have higher duration and lower reinvestment risk. These type of bonds have been issued in Australia, Canada, New Zealand, the UK and the USA.

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  eBook - PDF

  Capital Market Instruments

  Analysis and valuation

  • M. Choudhry, D. Joannas, R. Pereira, R. Pienaar(Authors)
  • 2004(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  The premium on the yield of the conventional bond over that of the index-linked DEBT MARKET INSTRUMENTS 198 t = { [1 + ½(0.0517)] } 2 – 1 = 0.029287 or 2.9% [1 + ½(0.0223] bond is therefore compensation against inflation to investors holding it. Bondhold- ers will choose to hold index-linked bonds instead of conventional bonds if they are worried by unexpected inflation. An individual’s view on expected inflation will depend on several factors, including the current macro-economic environment and the credibility of the monetary authorities, whether it is the central bank or the government. In certain countries such as the UK and New Zealand, the central bank has explicit inflation targets and investors may feel that over the long term these targets will be met. If the track record of the monetary authorities is proven, investors may feel further that inflation is no longer a significant issue. In these situations the case for holding index-linked bonds is weakened. The real-yield level on indexed bonds in other markets is also a factor. As capi- tal markets around the world have become closely integrated in the last 20 years, global capital mobility means that high-inflation markets are shunned by investors. Therefore over time expected returns, certainly in developed and liquid markets, should be roughly equal, so that real yields are at similar levels around the world. If we accept this premise, we would then expect the real yield on index-linked bonds to be at approximately similar levels, whatever market they are traded in. For example we would expect indexed bonds in the UK to be at a level near to that in, say, the US market. In fact in May 1999 long-dated index-linked gilts traded at just over 2% real yield, while long-dated indexed bonds in the United States were at the higher real yield level of 3.8%.

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  Law and Inflation

  • Keith S. Rosenn(Author)
  • 2015(Publication Date)
  • University of Pennsylvania Press

    (Publisher)

  If expectations are different, borrowers who anticipate that the inflation rate will be less than that implicitly factored into the nominal market interest rate on nonindexed bonds and notes will issue indexed bonds and notes. To these bprrowers, indexing means a drop in the per-ceived real interest rate, which implies an increase in investment demand. Correspondingly, lenders who anticipate that the inflation rate prediction in the going nominal interest rate is too low will buy indexed bonds and notes. To these lenders, indexing means an increase in the perceived real interest rate, which implies an increase in the savings rate. Under Robson's analysis, it is impossible to tell whether indexation of credit transactions is inflationary or not because investment and savings will both rise. In the long run, debt indexation should increase capital formation, which, in turn will have an anti-inflationary effect. 75 Robson's analysis ignores the tax implications, which can decidedly change the picture. Some countries specifically exempt indexation gains from taxation, while taxing nonindexed gains in their entirety. 76 If they need not pay income tax on monetary correction gains, lenders should be content with far lower rates of return on indexed obligations. 77 With a marginal tax rate of 40 percent on interest income and an annual inflation rate of 10 percent, a lender would have to charge an annual interest rate of 20.7 percent to receive a real return equivalent to that realized by charging 4 percent a year interest in a noninflationary period. If the loan were indexed and the inflation adjustment were tax-exempt, a total nomi-397 3 9 8 L A W A N D I N F L A T I O N nal yield of 14 percent a year would be sufficient. If the borrower is denied a corresponding deduction for the inflation adjustment, as happens in certain countries, 78 the attractiveness of indexed financing relative to nonindexed financing also becomes a function of the borrower's marginal tax rate.

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  Advances in Risk Management

  • G. Gregoriou(Author)
  • 2006(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  An inflation-linked bond with deflation protection can be seen as the combination of the inflation index (replicating strategy (9.20)) and the conventional bond (the remaining part of (9.5)), for example, can be replicated by the inflation index and this conventional bond. 180 OPTIMAL INVESTMENT WITH INFLATION-LINKED PRODUCTS 0 0.45 0.5 0.55 0.6 0.65 0.7 1 (t) 0.75 0.8 0.85 0.9 0.95 5 10 15 t 20 25 30 Zero inf.-bond Inf.-bond Inf.-bond with deflation Figure 9.2 Optimal portfolio process of inflation-linked bonds with different structure characteristics In order to maintain this optimal pure fraction of the bond and inflation index (stock) in the portfolio, one has to increase the relative fraction of the inflation-bond in the portfolio, when the inflation index is getting lower, because the replicating strategy (9.20) becomes smaller, too. The other interesting aspect of this example is the asymptotic behavior of the optimal portfolio processes of inflation-linked bonds with deflation pro- tection at the maturity date T. Depending on the level of the inflation index I (t) the price of the inflation-linked bond B IL (t, I (t)) approaches three differ- ent asymptotical forms. In the case of inflation, for example, when I (t) > I (t 0 ), the asymptote is equal to ψ(t)I (t). For I (t) = I (t 0 ) we have ψ(t)I (t) + F/2 as an asymptote and in the case of deflation, for example, I (t) < I (t 0 ), the asymptotic function for B IL (t, I (t)) is ψ(t)I (t) + F. In these different cases the asymptotic representations of the optimal portfolio process π 1 (t) are: π 1 (t) ∼ λσ I − r R (1 − γ )σ 2 I , t → T, I (t) > I (t 0 ) π 1 (t) ∼ λσ I − r R (1 − γ )σ 2 I 1 + F 2ψ(t)I (t) , t → T, I (t) = I (t 0 ) TARAS BELETSKI AND RALF KORN 181 π 1 (t) ∼ λσ I − r R (1 − γ )σ 2 I 1 + F ψ(t)I (t) , t → T, I (t) < I (t 0 ) This asymptotic behavior of the optimal portfolio process π 1 (t) shows the same feature as the inverse dependence between the optimal portfolio pro- cess and inflation index I (t).

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  The Sterling Bonds and Fixed Income Handbook

  A practical guide for investors and advisers

  • Mark Glowrey(Author)
  • 2013(Publication Date)
  • Harriman House

    (Publisher)

  The natural buyer of index-linked gilts is a large pension fund, the trustees of whom need to match long-term index-linked liabilities. Such investors are prepared to give up a degree of performance in the security in return for a government-guaranteed hedge against inflation. Thus, all things being equal, one might expect index-linked gilts to underperform other more risk-positive assets over time.

  This is a fair assumption, however, with index-linked gilts, as with most other asset classes, every dog will have its day. An investor or trader purchasing inflation-linked securities during a period of low inflation expectations may be pleasantly surprised by the performance of such bonds when those expectations shift. They can also offer a surprisingly tax-efficient solution during periods of high inflation.

  Linkers are not one of my favourite types of bonds, but they are undoubtedly worth monitoring as the performance of the UKTI 2.5% 2020 over the 2009-2010 period demonstrates in the chart below.

  Chart 8.1: price performance of index-linked gilt (2007-2010)

  Consider also that capital gains for the private investor will be tax free. In times of high inflation, this may put this asset class firmly on the buying list for higher-rate taxpayers.

  Note : Unlike the index-linked saving certificates issued by the government’s NS&I (until recently, available through the Post Office), index-linked gilts do not have a floor. If inflation proves to be negative over the holding period, the investor may receive less than he put in. However, this event has yet to occur over the 30-year history of these instruments.

  Passage contains an image

  Chapter 9: Domestic and Eurosterling corporate bonds

  The majority of corporate bonds that the investor will encounter in the sterling bond markets are technically defined as Eurosterling bonds

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