Inflation linked bonds’ mechanism

What is an inflation linked bond?

Inflation Lndexed bonds are bonds (ILB) have been around for a long time but their major development within organized exchanges has taken place over the last 30 years when Great Britain became the first industrialized country to issue inflation linked Gilts in 1981. Since then, they have been solicited by governments (France became the first European country to issue ILB in 1998) and markets which have used them as protection against inflation but also for portfolio diversification purposes (ILBs are less sensitive to interest rate movements compared to nominal bonds). All categories of investors looking to protect their purchasing power can use ILBs.

ILBs are bonds whose principals (The amount which borrowers need to reimburse at the bond’s maturity) are indexed on inflation. They differentiate themselves from traditional bonds through two aspects:

1. The nominal value of coupons is the sum of a constant real coupon which is established in advance and observed inflation (usually made through a consumer price index);
2. The final payment is also indexed on observed inflation but is generally guaranteed during deflation.

The coupon is calculated as follows: Coupon = Nominal * Interest rate * Indexation Coefficient.
Real coupons and the capital are therefore multiplied by the increase in the reference inflation index of the issuing country between the issue date and the coupon date.
The inflation index on a given date t is given by: I(t) = CPI (t-3 months) + ((CPI (t-2 months) – CPI (t-3 months)) * (jour (t) – 1) / number of days (month (t)) where CPI is the Consumer Price Index.

What are the advantages of holding an inflation linked bond?

ILBs allow their holders to protect themselves against inflation which is not the case of traditional bonds (an investor is negatively impacted in real terms when the price index rises)

ILBs therefore have two dimensions:
 1.A dynamic element: the real part (net of inflation)

• It only includes anticipations on real interest returns.

 2.A mechanical element: the capitalization of inflation over the lifespan of the bond

• The indexation ratio based on a Consumer Price Index (CPI) measuring inflation (or deflation) within the issuing zone.

The price ILBs vary according to:
 The evolution of real rates
 Their indexation on inflation

At the beginning of the previous century, the economist Irving Fischer highlighted the integration of inflationary anticipations within nominal interest rates through his famous equation:

Implicit inflation is inflation which balances the returns of traditional bonds with those of Inflation Indexed Bonds.

It is better to purchase an ILB if an inflation level above the implicit inflation level or break even is expected. In the USA, this would currently be the equivalent of betting on a projected inflation rate which is higher than 2.1% on average over the next 10 years.