Inflation Bond


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Inflation Indexed Bond Valuation


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Inflation indexed bonds, also called inflation linked bonds or real return bonds, are bonds where the principal is indexed to inflation or deflation on a daily basis in terms of a reference index, such as Consumer Price Index (CPI).


1. Inflation Indexed Bond Introduction

The CPI is the proxy for inflation that measures price changes in a basket of goods and services. The main idea of inflation indexed bonds is that investing in the bond will generate a certain real return. Inflation indexed bonds pay a periodic coupon that is equal to the product of the daily inflation index and the nominal coupon rate. Therefore, even though the nominal value of the coupons and principal may change, the real return of these remains the same. Unlike regular (nominal) fixed rate bonds, inflation indexed bonds assure that your purchasing power is maintained regardless of the future rate of inflation.

An inflation indexed bond is designed to hedge the inflation risk of the bond. Since inflation indexed bonds offer investors a very high level of safety, their coupons are typically lower than high-yield bonds. It is an important vehicle for investors hose liabilities indexed to changes in inflation or wages. Inflation indexed bonds have favorable performance and lower volatility relative to other risk assets. It is favorable to retirement planning and pension funds given its inflation protection. Inflation indexed bonds are less liquid than regular bonds.


2. Inflation Indexed Bond Valuation

The present value of an inflation indexed bond is given by

Inflation linked bond valuation in FinPricing

Practical Notes

  • First construct inflation curve by bootstrapping either breakeven inflation swap rates or treasury inflation protected securities (TIPS).
  • Compute the base reference CPIs at the issue date and each payment date.
  • Adjust the coupons and principal based on CPI ratio at each payment date.
  • Discount all the coupons and principal to the valuation date.
  • The bond price is the sum of all the present values.

3. Related Topics: Fixed Rate Bond

A fixed rate bond pays coupons at a fixed rate over the bond life. An investor who wants to earn a guaranteed interest rate for a specified term can choose fixed rate bonds. Due to the fixed coupon, the market value of a fixed rate bond is susceptible to fluctuation in interest rate and therefore has a significant interest rate risk.

The present value of a fixed rate bond can be expressed as

Fixed rate bond valuation in FinPricing

References