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Inflation-indexed bonds (also known as linkers) are bonds where the principal is indexed to inflation, and thus purports to cut out the inflation risk^[1]. 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.

See also: inflation derivatives

Inflation-indexed bonds pay a coupon that is equivalent to the sum of the increase in an inflation index and the real coupon rate. The relationship between coupon payments, breakeven inflation and real interest rates is given by the Fisher equation. A rise in coupon payments is a result of an increase in inflation expectations, real rates, or both.

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.

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, Germany, Canada, Greece, Italy, Japan, Sweden and Iceland also issue inflation-indexed bonds.^[2]

See also: Bond market index

Inflation-indexed bond indices include Barclays World Government Inflation-Linked Index.

1. ^ . Unfortunately, income taxes bring some inflation risk back to such bonds. See tax on the inflation tax
2. ^ Real Return Bonds. Retrieved on 2006-06-30.
3. ^ TIPS In Depth. Retrieved on 2006-06-30.
4. ^ OAT€is AND BTAN€is. Retrieved on 2006-06-30.
5. ^ Government of Canada Market Debt Instruments. Retrieved on 2006-06-30.

• Fisher equation

• Inflation-Linked Bond Basics
• TIPS
• Inflation-linked Gilts
• French inflation-indexed bonds
• inflationderivatives.com
• Treasury Inflation Protected Securities - The Basics

• Deacon, Mark, Andrew Derry, and Dariush Mirfendereski; Inflation-Indexed Securities: Bonds, Swaps, and Other Derivatives (2nd edition, 2004) Wiley Finance. ISBN 0-470-86812-0.