Inflation linked bonds - why do they issue them?

londonman81

I've been thinking about inflation linked bonds lately (those issued by governments and corporations for mainly institutional investors, although I guess the same/similar logic would apply for retail investors).

I'd like to understand:

1. How the issuer is able to stump up the extra cash needed to make the inflation linked coupon payment. i.e. normal bonds pay a known coupon amount, but if RPI jumps up suddenly, then how does the issuer guarantee that they will be able to match the jump?

2. Why would any government/corporation issue an inflation linked bond versus just regular bond where the coupon payments are known in advance and would not require having to stump up cash as inflation moves around?

Just am trying to figure out what the benefit for the issuer is in issuing inflation linked bonds.

Also - just taking it a step further - why aren't all bonds inflation linked? Why would someone choose not to have their coupon payment linked to inflation? My logic would tell me that all investors should prefer inflation linked bonds, and if there is no burden on the issuer then why aren't all bonds inflation linked?

Thanks

grizzly1911

londonman81 wrote: »

I've been thinking about inflation linked bonds lately (those issued by governments and corporations for mainly institutional investors, although I guess the same/similar logic would apply for retail investors).

I'd like to understand:

1. How the issuer is able to stump up the extra cash needed to make the inflation linked coupon payment. i.e. normal bonds pay a known coupon amount, but if RPI jumps up suddenly, then how does the issuer guarantee that they will be able to match the jump?

2. Why would any government/corporation issue an inflation linked bond versus just regular bond where the coupon payments are known in advance and would not require having to stump up cash as inflation moves around?

Just am trying to figure out what the benefit for the issuer is in issuing inflation linked bonds.

Also - just taking it a step further - why aren't all bonds inflation linked? Why would someone choose not to have their coupon payment linked to inflation? My logic would tell me that all investors should prefer inflation linked bonds, and if there is no burden on the issuer then why aren't all bonds inflation linked?

Thanks

I have theory that government linked bonds get introduced when they have a good idea inflation is coming down rather than issuing higher rate locked in bonds.

They (government) always seem to t hastily withdraw them when inflation looks like it is going to take off.

Masomnia

I think it's about diversification. Index linked bonds might work out better, they might work out worse; same for standard bonds. So a bit of both on average will work out best. That's the way I think about it any way.

Index linked gilts are popular, so selling them is good for the government as the demand keeps the yields lower.

And those savings certificates, they do seem to withdraw them entirely based on market conditions. Why would they borrow from you at RPI+x% for five years when they can borrow at 1.7% for ten years on the gilt market?

kidmugsy

Nothing is entirely secure. For many decades in the US people got the equivalent of inflation-protection on the capital value of bonds by having the terms include the creditor's right to demand repayment in either USD or in gold, in some predefined amount.

FDR induced Congress to pass an Act retrospectively tearing up the T&Cs, so that only repayment in USD could be demanded. Disgustingly, the Supreme Court decided that this act of larceny was constitutional. (There's not much point having a codified constitution if it is ignored whenever there is a crisis.)

I suppose a modern British equivalent would be to declare retrospectively that index-linking on bonds would be suppressed altogether, or that RPI-linking on bonds would be replaced retrospectively by some inferior index contrary to the original T&Cs.

P.S. Of course, there will shortly be someone along to argue that replacing RPI-linking for official pensions by CPI-linking is equally larceny. He will be quite wrong; the terms of official pensions were always that they would be linked to an inflation rate of the government's choice, not specifically to RPI.

Declarations of interest: (i) My wife and I no longer hold Fixed Interest Gilts, only index-linked - but only short duration index-linked, conscious as we are that there will be a General Election in 2015. (ii) My principal pension has had RPI-linking replaced by CPI-linking. I don't like it, but I'm not so stupid or dishonest as to call it larceny.

Cygnus_Alpha

For government index linked bonds, the simple answer is that there is heavy demand for such bonds and therefore they get a good price.

A similar reason applies for corporates. But also some corporates will have income linked to inflation (water companies) and so can use this to match the index linked coupons.

FatherAbraham

londonman81 wrote: »

1. How the issuer is able to stump up the extra cash needed to make the inflation linked coupon payment. i.e. normal bonds pay a known coupon amount, but if RPI jumps up suddenly, then how does the issuer guarantee that they will be able to match the jump?

The issuer of a bond pays coupon ("interest"), and repays the principal from income received, or further borrowing. The only guarantee is the borrower's desire to maintain its reputation (called "credit-worthiness").

londonman81 wrote: »

2. Why would any government/corporation issue an inflation linked bond versus just regular bond where the coupon payments are known in advance and would not require having to stump up cash as inflation moves around?

Just am trying to figure out what the benefit for the issuer is in issuing inflation linked bonds.

An inflation-linked bond commands a higher price in the market, all things being equal, because the issuer is carrying risk which otherwise would lie with the lender. There's no free lunch.

londonman81 wrote: »

Also - just taking it a step further - why aren't all bonds inflation linked? Why would someone choose not to have their coupon payment linked to inflation? My logic would tell me that all investors should prefer inflation linked bonds, and if there is no burden on the issuer then why aren't all bonds inflation linked?

Further logic should tell you that the preference for index-linked bonds will be tempered by demand driving prices up. At some price level, it's not worth paying for the insurance offered by index-linked bonds.

An investor (such as an institution) which buys a lot of non-index-linked bonds, will both win and lose on interest-rate movements in the long run. Occasional high inflation will cause severe damage to a portfolio, but psychologically, investors tend to underestimate the risks of such situations. Or maybe it's priced in already. Who knows? These are questions for economists.

Warmest regards,
FA

kidmugsy

FatherAbraham wrote: »

These are questions for economists.

Cruel, cruel.