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An index-linked bond is an investment vehicle that is structured in the same fashion as a normal bond with extra protection added to mitigate the damage caused by inflation. The bond achieves this by linking the interest payments and, if held to maturity, the return of principal to some sort of national price index. As the index goes up, so too does the rate of return for investors holding the bond. In this way, investors purchasing an index-linked bond can be assured of the promised rate of return if they hold the bond all the way to maturity.
Under normal circumstances, a bond returns regular interest payments to investors at a predetermined rate known as the coupon. In addition, an investor that holds the bond to maturity is guaranteed the return of the original principal paid to purchase the bond. This type of bond does not take into account the fact that the value of the returns gained from the bond might not keep up with rising prices in the economy. To help eliminate the devaluation of investments that inflation can cause, an investor can purchase an index-linked bond.
The key characteristic of an index-linked bond is the way that its returns are based on some sort of price index, like the Consumer Price Index (CPI) in the United States, which measures inflation. If the benchmark index rises, the coupon payments due to the investor at each regular interval will rise approximately the same amount from the initial coupon rate. At the end of the bond term, the principal is also adjusted to reflect the effect if inflation.
What this process ensures is that the investor holding an index-linked bond will get the rate of return he or she desires. For example, an investor that gets a four percent coupon rate for a bond held for five years will lose out if inflation rises by seven percent in that same time. In a situation like that, the investor is in essence losing money on the investment by holding the bond to maturity.
There are some other drawbacks to consider when purchasing an index-linked bond. Although the principal is protected if the bond is held to maturity, the value of the bond can fluctuate while it is held. This can be problematic if the bondholder attempts to sell the bond at some point before maturity. In addition, investors must realize that decreasing inflation at any point during the bond term will negatively impact the value of the interest payments they will receive.