Index-Linked Bond

Index-linked bonds, also known as inflation-linked bonds, are indexed to an inflation index and as such offer holders protection against inflation. Sovereign governments are the principal issuers of such bonds, but utilities, housing associations, municipal authorities and others have also issued in this format. In essence, the principal and interest of an index-linked bond are linked to inflation and will rise or fall in tune with the relevant inflation index. Index-linked bonds pay real returns. The principal value adjusts in line with inflation while the coupon is fixed but is paid on the adjusted principal value. Some issuers offer investors deflation protection in the form of par value floors at maturity. A critical relative-value metric when looking at index-linked bonds is the so-called breakeven rate, which compares the real yield of index-linked bonds with the yield on standard bonds of the same issuer. The difference between the two equals what inflation expectations the market is pricing in. The breakeven is the annual inflation rate at which investors should be indifferent to owning an index-linked bond or a conventional bond. If the breakeven is higher than expected inflation, an investor would be better off holding a conventional bond. If the breakeven is below inflation expectations, index-linked bonds are the preferred instrument.