Certain countries have markets in bonds whose coupon or final redemption payment, or both, are linked to their consumer price indexes. Generally, the most liquid markets in these inflation-indexed, or index-linked, debt instruments are the ones for government issues. Investors’ experiences with the bonds differ, since the securities were introduced at different times in different markets and so are designed differently. In some markets, for instance, only the coupon payment, and not the redemption value, is index-linked. This makes comparisons in terms of factors such as yield difficult and has in the past hindered arbitrageurs seeking to exploit real yield differences. This chapter highlights the basic concepts behind indexed bonds and how their structures may differ from market to market.
The features considered in the design of index-linked bonds are the type of index, the indexation lag, the coupon frequency and the type of indexation.
Choice of index
In principle, bonds can be linked to almost any variable, including various price indexes, earnings measures, GDP output, specific commodities and the exchange rate of foreign currencies against another currency. Ideally, the chosen index should reflect the hedging requirements of both parties - that is, the issuer and the investor. Their needs, however, may not coincide. For instance, retail investors overwhelmingly favour indexation to consumer prices, to hedge against ...