Index-Linked Gilt

Definition of Index-Linked Gilt

An index-linked gilt is a government bond issued by the United Kingdom where interest and redemption payments are adjusted in line with inflation. Specifically, they are linked to the Retail Price Index (RPI), ensuring that the value of the bond’s payments increases in line with rising prices. This type of gilt offers protection against inflation, preserving the purchasing power of the investor’s returns.

How Do Index-Linked Gilts Work?

• Interest Payments: The interest payments (coupons) on an index-linked gilt are typically made semi-annually. The amount paid adjusts according to the ratio of the RPI at the start date of the interest period compared to the RPI at the end date of that period.
• Redemption Payments: At maturity, the redemption amount, which is the principal repayment, is also increased in line with the cumulative adjustment in the RPI since the gilt’s issue date.

Example

Suppose an investor holds an index-linked gilt with a principal value of £1,000. During the investment period:

• If the RPI was 200 at the start of the period and increased to 220 by the end, the interest payment and the redemption value would be adjusted upwards.
• For instance, if the initial semi-annual interest rate was 2%, the adjusted interest payment would be calculated as 2% of £1,100 (original principal adjusted by RPI increase of 10%), giving an interest payment of £22 instead of £20.
• Similarly, the redemption amount at maturity would be adjusted to account for inflation.

Frequently Asked Questions (FAQs)

1. Why should one invest in index-linked gilts?

• Investing in index-linked gilts provides protection against inflation. They ensure that the real value of interest and redemption payments is maintained, safeguarding the investor’s purchasing power.

2. How often are interest payments made on index-linked gilts?

• Interest payments are typically made semi-annually, but the actual frequency can differ depending on the specific terms of the gilt.

3. Are the principal and interest payments of index-linked gilts completely immune to government policy changes?

• While index-linked gilts are designed to protect investors against inflation as measured by the RPI, significant changes to government policy affecting inflation measures or alterations in taxation of gilts could impact their effectiveness.

4. How are the adjusted interest payments calculated?

• They are calculated using the formula: \( \text{Adjusted Interest} = \text{Base Interest Amount} \times \frac{\text{RPI at End of Period}}{\text{RPI at Start of Period}} \).

5. Is the Retail Price Index (RPI) the only measure used for adjusting index-linked gilts?

• While traditionally the RPI has been used, there have been discussions about switching to other measures like the Consumer Price Index (CPI) due to RPI’s methodological criticisms.

Related Terms

Gilt-Edged Security

• A high-grade bond issued by certain nation-states (including the UK), typically seen as a low-risk investment. Quality and reliability are the hallmark characteristics of gilt-edged securities.

Retail Price Index (RPI)

• A measure of inflation published monthly by the UK government, reflecting the changes in the cost of a representative basket of retail goods and services. It’s used to adjust payouts on index-linked gilts.

Coupon Rate

• The annual interest rate paid by the bond issuer, expressed as a percentage of the bond’s face value. For index-linked gilts, this rate adjusts in line with inflation.

Redemption Value

• The amount paid back to the bondholder upon maturity, adjusted for inflation in the case of index-linked gilts.

Online References

• UK Debt Management Office
• Bank of England – Gilt Market

Suggested Books for Further Studies

1. Fixed Income Securities: Tools for Today’s Markets by Bruce Tuckman and Angel Serrat
2. The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More by Annette Thau
3. The Handbook of Fixed Income Securities by Frank J. Fabozzi

Accounting Basics: “Index-Linked Gilt” Fundamentals Quiz

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