Saturday, 26 November 2011

Inflation-indexed bonds

Inflation-indexed bonds

Inflation-indexed bonds also known as inflation-linked bonds are government and commercial bonds indexed to inflation. The first known inflation-indexed bond was issued by The Massachusetts Bay Company in 1780.

The capital amount or principal of the bond is indexed to inflation. Inflation-indexed bonds are thus money loans to governments and companies designed to eliminate the risk of inflation eroding the real value of the principle and interest payments. The corporate inflation-indexed bond market is quite small compared to the sovereign market. The British government began issuing inflation-linked Gilts in 1981. The market for inflation-linked bonds has grown rapidly since then. Sovereign inflation-indexed bonds comprised over $2.68 trillion of the international debt market at the end of 2009. Private sector issued inflation-linked bonds make up a small portion of the international inflation-indexed bond market.

Interest is paid my means of coupon payments. A coupon payment on a bond is a periodic interest payment to the bondholder during the period between the bond issue date and when the bond matures. The coupon is equal to the product of the nominal coupon rate and the inflation index for the period involved. The Fisher equation presents the relationship between real interest rates, coupon payments and breakeven inflation. An increase in real rates, inflation expectations, or both, results in a rise in coupon payments.

The underlying principal of the bond is inflation-indexed for most bonds, such as in the case of Treasury Inflation-Protected Securities (TIPS), which results in a higher interest payment when multiplied by the same rate. The interest rate is adjusted according to inflation for some bonds, such as the Series I Savings Bonds in the US.

The most liquid markets are US TIPS, the UK Index-linked Gilts and the French OATi/OAT€I market. Japan, Germany, Italy, Canada, Australia, Sweden, Iceland, Portugal, Greece, Finland, Netherlands, Spain, Saudi Arabia, Qatar, Kuwait, UAE, South Korea New Zealand and Hong Kong also issue inflation-indexed bonds, as well as a number of Emerging Markets such as Brazil, Turkey, Chile, Mexico, Colombia, Argentina and South Africa.

Nicolaas Smith Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

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