how an index linked bond works
a bond investor holds a bond with a fixed interest rate the interest payments known as coupons are usually paid semi annually and represent the bondholder s return on investing in the bond however as time goes by inflation also increases thereby eroding the value of the investor s annual return this is unlike returns on equity and property in which dividend and rental income increase with inflation to mitigate the impact of inflation index linked bonds are issued by the government an index linked bond is a bond which has its coupon payments adjusted for inflation by linking the payments to some inflation indicator such as the consumer price index cpi or retail price index rpi these interest bearing investments typically pay investors a real yield plus accrued inflation providing a hedge against inflation the yield payment and principal amount are calculated in real terms not nominal numbers one can think of the cpi as the exchange rate that converts the return on a bond investment to a real return an indexed linked bond is valuable to investors because the real value of the bond is known from purchase and the risk involved with uncertainty is eliminated these bonds are also less volatile than nominal bonds and help investors maintain their purchasing power index linked bonds provide a real yield plus inflation with everything yield payment principal calculated in real terms not nominal example of an index linked bondconsider two investors one purchases a regular bond and another buys an index linked bond both bonds are issued and purchased for 100 during july 2019 having the same terms 4 coupon rate 1 year to maturity and 100 face value the cpi level at the time of issuance is 204 the regular bond pays an annual interest of 4 or 4 100 x 4 and the principal amount of 100 is repaid at maturity at maturity the principal and the interest payment due that is 100 4 104 will be credited to the bondholder assuming the cpi level in july 2020 is 207 the interest and principal value must be adjusted for inflation with the index linked bond coupon payments are calculated using an inflation adjusted principal amount and an indexation factor is used to determine the inflation adjusted principal amount for a given date the indexation factor is defined as the cpi value for the given date divided by the cpi at the original issue date of the bond the indexation factor in our example is 1 0147 207 204 therefore the inflation rate is 1 47 and the bondholder will receive 105 53 104 x 1 0147 when it matures the annual interest rate on the bond is 5 53 105 53 100 100 x 100 the investor s approximate real return rate is 4 06 5 53 1 47 calculated as the nominal rate less the inflation rate 