Inflation-indexed bonds annuity indexation

To obtain the price of an inflation-linked bond, it is necessary to determine the value of coupon payments and principal repayment. Inflation-linked bonds can be structured with a different cash flow indexation. As noted above, duration, tax treatment and reinvestment risk, are the main factors that affect the instrument design. For instance, index-aimuity bmids that give to the investor a fixed annuity payment and a variable element to compensate the inflation have the shortest duration and the highest reinvestment risk of aU inflation-linked bonds. Conversely, inflation-linked zero-coupon bonds have the highest duration of all inflation-linked bonds and do not have reinvestment risk. In addition, also the tax treatment affects the cash flow structure. In some bond markets, the inflation adjustment on the principal is treated as current income for tax purpose, while in other markets it is not. 

Index-linked bonds often pay interest semiannually. Certain long-dated investors, such as fund managers whose liabilities include inflation-indexed annuities, may be interested in indexed bonds that pay on a quarterly or even monthly basis. 

There are five basic methods of linking the cash flows from a bond to an inflation index interest indexation, capital indexation, zero-coupon indexation, annuity indexation, and current pay. Which method is chosen depends on the requirements of the issuers and of the investors they wish to attract. The principal factors considered in making this choice, according to Deacon and Derry (1998), are duration, reinvestment risk, and tax treatment. 

Annuity indexation. Indexed-annuity bonds have been issued in Australia, although not by the central government. They pay a fixed annuity payment plus a varying element that compensates for inflation. These bonds have the shortest duration and highest reinvestment risk of all index-linked debt securities. 

In the United States, Canada, and New Zealand, indexed bonds can be stripped, allowing coupon and principal cash flows to be traded separately. This obviates the need for specific issues of zero-coupon indexed securities, since the market can create products such as deferred-payment indexed bonds in response to specific investor demand. In markets allowing stripping of indexed government bonds, a strip is simply a single cash flow with an inflation adjustment. An exception to this is in New Zealand, where the cash flows are separated into three components the principal, the principal inflation adjustment, and the inflation-linked coupons—the latter being an indexed annuity. 

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