Inflation-indexed bond

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Inflation-indexed bonds (also known as linkers) are bonds whose principal are indexed to inflation, cutting out inflation risk*. The first known inflation-indexed bond was issued by the Massachusetts Bay Company in 1780. The market has grown dramatically since the British government began issuing inflation-linked Gilts in 1981. Today, the asset class comprises over $500 Billion of the international debt market. The market primarily consists of sovereign debt, with privately issued inflation-linked bonds constituting a small portion of the market. (Also see inflation derivatives)

*Unfortunately, income taxes bring some inflation risk back to such bonds. See tax on the inflation tax

[edit] Underlying Mechanism

A common misconception about these bonds is that the interest rate changes with inflation. What actually happens is that the underlying principal of the bond changes, which results in a higher interest payment when multiplied by the same rate. For example, if the coupon of a bond was 5%, and the underlying principal of the bond was 100 units, the bond would pay 5 units, assuming annual payments. If the inflation index then increased by 10%, the principal of the bond would then increase to 110 units. This is multiplied by the same coupon rate of 5%, which results in an interest payment of 5.5 units. The only known exception to this is the Australian Capital Indexed Bond, which also adjusts the interest rate.

[edit] Global issuance

Best known in the U.S. are Treasury Inflation-Protected Securities (TIPS), a type of US Treasury security. The UK also issues Index-linked Gilts. The Australian government stopped issuing the Capital Indexed Bond in 2003. The Australian bond was unique among inflation-linked bonds in that the rate of interest and the principal were both linked to inflation. France, Canada, Greece, Italy, Japan, and Sweden also issue Inflation Indexed Bonds.