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BOND MATH: The Theory Behind the Formulas by Donald J. Smith

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Linker Taxation

This discussion of the taxation of inflation-indexed bonds is going to be simplistic, especially after the detail of Chapter 4. The stylized P-Linker and C-Linker are assumed to be purchased at par value and held to maturity. There are no capital gains or losses and no de minimis OID, just ordinary income tax. My objective is to demonstrate that these two designs offering inflation protection generate very different after-tax cash flows. Moreover, when the inflation rate is high, the after-tax real rates of return become negative. That explains why linkers usually are held in tax-deferred, retirement portfolios like defined-benefit and defined-contribution pension funds.

TABLE 7.5 After-Tax Cash Flows on the 2.50%, 10-Year, Annual ...

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