Zero-coupon indexation

Inflation-Linked Bonds with Zero-Coupon Indexation Zero-coupon bonds linked to the inflation do not pay coupons. Therefore, the unique adjustment is made to the principal. These types of bonds offer no... 

Table 6.2 illustrates the cash flow structure of an inflation-linked bond with zero-coupon indexation. 

As noted above for inflation-linked bonds with zero-coupon indexation, the coupon can be adjusted in a similar way ... 

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. 

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. 

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. 

Finally, there are a number of structured derivative products often marketed as new asset classes. Such products are usually perturbations of existing assets. For example, enhanced index products are typictdly a weighted combination of exposure to a specific equities or bond class, augmented with exposure to a particular hedge fund strategy. Similarly, yield-enhanced cash substitutes with principal guarantee features are composed of zero coupon Treasuries with the residual cash invested in options or other derivatives. Such products are part hedge fund and part primary asset from an allocation perspective and are better viewed as implementation vehicles rather than incorporated exphcitly in the asset allocation. 

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. 

TABLE 6.2 The Cash Flow Structure with Zero-Coupon Bond Indexation... 

However, the subtraction form is widely accepted. After all, there are other difficulties involved which have to be accepted—invariably there is a term mismatch between linker and comparator, there is reinvestment risk, and there is the fact that the real yield is not a pnre real yield (as we explained in the UK section), because of the indexation lag. A truer measure of break-even inflation would be achieved if we were lucky enough to have zero coupon linkers with no lag and a zero coupon nominal of identical term. 

Reinvestment risk. Like holders of a conventional bond, investors in a coupon indexed bond are exposed to reinvestment risk because they cannot know in advance what rates will be in effect when the bond s coupon payments are made, investors cannot be sure when they purchase their bond what yield they will earn by holding it to maturity. Bonds, such as indexed annuities, that pay more of their return in the form of coupons carry more reinvestment risk. Indexed zero-coupon bonds, like their conventional counterparts, carry none. 

Synthetic convertible notes are securities with fixed coupons, typically set at a relatively low level, whose total return is linked to an external source, such as the level of an equity index or the price of a specific security. In one common structure, the note is redeemable above par if the reference index or security value exceeds a stated minimum. The notes thus give investors the opportunity to profit from the benchmarks performance while providing the safety net of redemption at par should this performance fall short. Another typical synthetic convertible structure is the zero-coupon note. These notes are issued at par and redeemable at par, or higher, if a specified equity index performs better than a stated level. 

Using equation 14.16, we can build a forward inflation curve provided we have the values of the index at present, as well as a set of zero-coupon bond prices of required credit quality. Following standard yield curve analysis, we may build the term structure from forward rates and therefore imply the real yield curve, or alternatively we may construct the real curve and project the forward rates. However, if we are using inflation swaps for the market price inputs, the former method is preferred because IL swaps are usually quoted in terms of a forward index value. 

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