Inflation-indexed bonds reinvestment risk

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. 

On a hold-to-maturity basis, as we ve said, inflation-linked government bonds provide as close an approximation to a guaranteed real return as is currently available. If we can assume the government is credit risk-free, then there remain only two modest reasons for us to couch the above statement with the cautionary nse of the word approximation. There will inevitably always be a small conpon reinvestment risk and also a small degree of real value uncertainty becanse of the indexation lag. 

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. 

Capital indexation. Capital-indexed bonds have been issued in the United States, Australia, Canada, New Zealand, and the United Kingdom. Their coupon rates are specified in real terms, meaning that the coupon paid guarantees the real amount. For example, if the coupon is stated as 2 percent, what the buyer really gets is 2 percent after adjustment for inflation. Each period, this rate is applied to the inflation-adjusted principal amount to produce the coupon payment amount. At maturity, the principal repayment is the product of the bond s nominal value times the cumulative change in the index since issuance. Compared with interest-indexed bonds of similar maturity, these bonds have longer durations and lower reinvestment risk. 

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. 

Zero-coupon indexation. Zero-coupon indexed bonds have been issued in Sweden. As their name implies, they pay no coupons the entire inflation adjustment occurs at maturity, applied to their redemption value. These bonds have the longest duration of all indexed securities and no reinvestment risk. 

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See also in sourсe #XX -- [ ]

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