What Are Indexed Bonds and How Do They Work?

Bonds have always been a solid and popular investment tool, ideal for those looking for a stable source of income and moderate risk. Among the various options available on the market, indexed bonds stand out for their ability to adapt to variable economic contexts, offering protection against inflation.

But what are indexed bonds? How do they actually work? Questions that those who are not experts in the bond market might ask themselves when faced with this financial instrument. Here’s everything you need to know.

What Are Indexed Bonds: Meaning and Definition

Indexed bonds are debt securities whose yield is linked to an economic or financial index, often a consumer price index (CPI) or an inflation index.

This characteristic makes them unique compared to traditional bonds, whose yield is fixed or based on a predetermined variable rate. The main objective of indexed bonds is to preserve the purchasing power of the investor, automatically adapting to changes in the general level of prices.

But what are the differences between indexed and non-indexed?

• Yield: Traditional bonds offer a fixed interest rate that can be vulnerable to inflation. In contrast, the yield of index-linked bonds rises or falls in line with the benchmark index.
• Inflation risk: Index-linked bonds protect against rising prices, ensuring that the real value of the principal and interest is not eroded. Non-index-linked bonds, on the other hand, can lose real value in periods of high inflation.
• Price and duration: Index-linked bonds tend to have greater short-term price volatility, as their value is influenced by both interest rates and the underlying index.

A common example of indexed bonds are Treasury Inflation-Protected Securities (TIPS) in the United States and BTP Italia in Italy, which offer specific protection against local inflation.

Indexed bonds: how they work

We have tried to give a definition of these bonds as clear as possible, now let’s see how they work and how their value changes based on the index.

These bonds can take on various characteristics, but they are all characterized by the adjustment to a specific market index. The adjustment of indexed bonds is intended to preserve the profitability of the investment in the face of changing financial conditions on the market.

In other words, this indexation tends to safeguard the creditor’s interest from any depreciation of the currency, especially for long-term bonds that are more subject to market variations.
In the past, it was common to use indexation clauses referring to the value of gold, which therefore adjusted the value of the service to the market price of gold.

The adjustment of the indexation now depends on various reference parameters; one or more of these parameters can be linked to the indexed bond. The indexation of the index will be adjusted based on their performance on the market.

Reference parameters

Indexed bonds can take on very different characteristics and the reference parameters can be of three types:

• of real nature: the indexation is of real nature when the coupons depend on the performance of the inflation rate;
• of financial nature: this is financial indexation when the reference variable is an interest rate. Indexed bonds of a financial nature are the most widespread type;
• currency nature: currency indexation occurs when the amount of the coupons is determined by the evolution of an exchange rate.

Indexation clauses can be established by law, by the negotiating parties in the exercise of their private autonomy, or by judicial means. As anticipated, a clear example of a bond indexed to the inflation rate is represented by BTP Italia.

Example of operation

Indexed bonds operate by linking their payments of principal and interest to a reference index. Here is a detailed analysis of how they work.

• Capital indexation: at maturity, the capital repaid is adjusted based on the performance of the underlying index. For example, if inflation has increased by 5% during the duration of the bond, the capital repaid will be increased by the same value.
• Interest Payments: Interest is calculated on the indexed principal, making it variable. This means that as inflation increases, so does interest.
• Deflation Protection: In some cases, indexed bonds offer a minimum guarantee on the principal, protecting the investor even in deflationary scenarios.
• Secondary Market: Indexed bonds can be bought or sold on the secondary market, and their price varies based on inflation expectations and interest rates.

Suppose you buy a CPI-indexed bond with an initial principal of €10,000 and an interest rate of 2%. If the CPI increases by 3% during the first year, the indexed principal becomes €10,300. The first year’s interest will therefore be calculated on €10,300, equal to €206.

Indexed bonds: the reference types

Based on the reference parameters that the bond has, there will be two different types of bonds. The difference in the bond will be reflected in the payment that will be received by the investor. In fact, we have:

1. fully indexed bonds: the change in the reference parameter will be reflected entirely on the investor’s coupon;
2. partially indexed bonds: only a part is reflected in the investor’s coupon or reimbursement; this part is called the retrocession percentage.

The reimbursement that will be received at the maturity of the subscribed bond will therefore also depend on which type of indexed bond has been chosen.

Investing in Indexed Bonds: When to Invest

Investing in indexed bonds can be an effective strategy to protect your portfolio against inflation and obtain stable returns. But when to invest?

• Periods of High Inflation: Indexed bonds are particularly useful in economic environments characterized by high or rising inflation.
• Portfolio Diversification: Even in periods of low inflation, these bonds can act as a tool for diversification and protection.

Recent data from institutions such as the World Bank and the OECD suggest that indexed bonds continue to be a valid protection against the erosion of purchasing power. In addition, many online platforms, such as Morningstar and Bloomberg, provide tools to analyze the historical performance and future prospects of these securities.

Whether you are an experienced investor or a beginner, understanding the workings and benefits of index bonds will allow you to make informed choices and maximize your long-term returns.

Original article published on Money.it Italy. Original title: Cosa sono le obbligazioni indicizzate e come funzionano