By Marsel Paraev
HOW DO ILB’s WORK?
An ILB’s explicit link to a nationally-recognized inflation measure means that any increase in price levels directly translates into higher principal values.
As a hypothetical example, consider a $1,000 20-year U.S. TIPS with a 2.5% coupon (1.25% on semiannual basis), and an inflation rate of 4%. The principal on the TIPS note will adjust upward on a daily basis to account for the 4% inflation rate. At maturity, the principal value will be $2,208 (4% per year, compounded semiannually). Additionally, while the coupon rate remains fixed at 2.5%, the dollar value of each interest payment will rise, as the coupon will be paid on the inflation-adjusted principal value. The first semiannual coupon of 1.25% paid on the inflation adjusted principal of $1,020 is $12.75, while the final semiannual interest payment will be 1.25% of $2,208, which is $27.60. While the exact mechanism for calculating payments can differ across specific issuers, all ILBs are designed to provide investors with returns contractually linked to inflation that may be used as a tool to hedge against rising price levels.
The inflation hedge offered by ILBs is important because every investor and consumer is exposed to inflation, and should consider having some measure of inflation protection in their portfolio. Since traditional asset classes such as stocks and bonds – which tend to dominate many portfolios – can be adversely affected by periods of persistent inflation, ILBs, with their explicit link to changes in inflation, are an effective way to incorporate explicit real returns into a portfolio.
What Is a Variable Interest Rate?
A variable interest rate (sometimes called an “adjustable” or a “floating” rate) is an interest rate on a loan or security that fluctuates over time because it is based on an underlying benchmark interest rate or index that changes periodically.
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ILBs, with their explicit link to changes in inflation, are an effective way to incorporate explicit real returns into a portfolio.
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