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Inflation Linked Bonds unpacked
The coupon rate, although fixed, is paid on the adjusted principal amount.
This is in comparison to a conventional, fixed rate or nominal bond where the coupon and principal amounts are fixed. The table alongside illustrates the cashflows on a notional value of 100 for a fixed rate bond compared to an inflation-linked bond.
|
Period in years |
Fixed rate bond cashflows |
Inflation-linked bond cashflows |
Inflation adjusted principal for ILB |
|
0.5 |
3.00 |
3.00 |
102.96 |
|
1.0 |
3.00 |
3.09 |
106.00 |
|
1.5 |
3.00 |
3.18 |
109.13 |
|
2.0 |
3.00 |
3.27 |
112.36 |
|
2.5 |
3.00 |
3.37 |
115.68 |
|
3.0 |
3.00 |
3.47 |
119.10 |
|
3.5 |
3.00 |
3.57 |
122.62 |
|
4.0 |
3.00 |
3.68 |
126.25 |
|
4.5 |
3.00 |
3.79 |
129.98 |
|
5.0 |
103.00 |
137.72 |
133.82 |
The assumptions are an inflation rate of 6% per annum, a coupon rate of 6% per annum and a term to maturity of 5 years. The inflation index used in the South African market is the headline Consumer Price Index (CPI).
In addition to being able to match the inflation rate, an investor in an inflation linked bond (ILB) receives a real yield. This is the yield at which the ILB trades in the market and it fluctuates according to market conditions. It is a yield earned in excess of inflation and currently has a value of around 2.5% on longer dated RSA ILBs.
The first ILBs in the South African market were issued by the RSA government in March 2000. Initially the market was slow to take off, with auctions in RSA government ILBs once a month. Larger government funding needs in recent years have seen an increase in the frequency and size of auctions.
Since April 2009, auctions have been held every Friday with sizes of between R500in and Rlbn. This has enhanced the liquidity in the market and ILBs are becoming a valuable tool for investors.
With the market increasing in size, the number of ILBs has also increased.
We currently have 6 RSA ILBs ranging in maturity from 3 to 22 years.
In recent years a market in non-government ILBs has also developed with a number of banks as well as state owned enterprises also issuing ILBs and therefore enhancing the market further.
The chart above shows the real yields on the 6 RSA ILBs. his evident that the real yields fluctuate according to market conditions. The real yields on the shorter dated bonds are substantially lower than those on the longer dated bonds.
ILBs are a valuable instrument for investors as they provide protection against future inflation risk.
They currently provide investors with a return above the inflation rate provided the ILB is held to maturity.
This may not always be true in the short term due to market fluctuations in the level of real yield.
