The Benefits and Costs of Index-Linked Bonds

The index-linked bond is a type of investment that can provide you with several benefits as an investor. An index-linked bond is a type of bond that is tied to the performance of a financial index. The rate of return that is received by the investor is adjusted depending on the performance of the financial index. If the index performs well, the bond is also going to perform well. If the index declines in value, the bond is not going to pay as much in interest.

Greater Potential

One of the big advantages of this type of bond is that it has greater potential than a traditional bond. Most regular bonds will pay a fixed coupon rate regardless of what happens in the market. This means that regardless of how good things turn out in the financial sector, you are still going to receive only will was agreed upon when you decided to purchase the bond. This is not the case with an index-linked bond. If things in the financial sector improve, your bond is going to be able to provide you with better returns. This is good for those individuals that want the fixed income of a bond but also want to be able to benefit from increases in market value at the same time.

Inflation Hedge

This type of bond can also be used as a hedge against inflation. Many of the index-linked bonds are tied to the Consumer Price Index. The Consumer Price Index is commonly used as a measurement of how much inflation is taking place in the economy. The index measures the difference in the cost to maintain a constant standard of living. Changes in the index are going to change the amount of payment that is received by bondholders. This makes the index-linked bond a better bet against inflation than a traditional bond. For example, if you invest in a regular bond that pays five percent and inflation is three percent, you are only going to net two percent. With an index-linked bond, if inflation is three percent, the bond payments will be adjusted so that you still receive five percent.

Drawbacks

Even though this type of bond can be beneficial, it is not perfect in all situations. In some cases, a regular bond is going to provide you with better possibilities. If the index that the bond is linked to does not perform well, the value of your bond is going to be lacking. For example, if the financial index only increases by one percent over the course of the year, your bond will pay out less than what you could get from a traditional bond. This means that you are increasing the amount of market risk that you are taking on with this type of bond. 

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