Linkers, or inflation-indexed bonds, adjust returns for inflation to guarantee a real return for investors. This reduces risk, but may result in a slightly lower yield compared to other bonds.
Linkers are a type of bond where the interest payment is linked to inflation. They are formally known as inflation-indexed bonds. The idea of the bond is that the investor knows what the return will be in real terms and does not have to worry about the effects of inflation. In theory, this lack of risk should mean that the offer yield is slightly lower for pegs than with other bonds.
A bond is a type of debt product whereby an investor pays money to a company to buy a bond. On the bond’s fixed maturity date, the investor gets back the money he originally paid, plus an interest payment known as a coupon. In most cases, the bond can be bought and sold on the open market until it expires, so the person cashing it in will often not be the original investor.
Typically, a bond simply pays a fixed interest rate. For example, an investor might buy a $100 US dollar (USD) five-year bond with a 20% coupon. This means that the investor will get back $120 at the end of the five year period. In some cases, there will be regular payments throughout the life of the bond. A five-year $100 bond with a 5% annual coupon will pay $5 per year, plus repay the original $100 at the end of five years.
The danger is that some or all of the return will be affected by inflation. In the first example above, inflation may mean that average goods that cost $100 at the beginning of the five-year period cost $110 at the end of the period. This would mean that although the investor has made a profit of $20 USD, they are only better off by $10 USD in real terms.
Linkers address this by adjusting returns for inflation. The precise method used varies with different binders, and may involve changing the principal used to calculate the final payment, the interest rate used to calculate the payment, or both. The general idea is always the same: the investor gets enough money to recover the guaranteed return once the effects of inflation are taken into account.
To take the last example above, each individual payment could be adjusted for inflation. For example, at the end of the first year, the investor would receive a payment that combines the 5% coupon rate with an additional amount equal to the coupon rate multiplied by the inflation rate. If the inflation rate were 3%, the investor would get back 5% plus 0.15%, totaling 5.15% or $5.15 USD. This is the amount needed to ensure that the investor gets back the promised 5% in real terms.
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