This tutorial outlines the reasons for using index-linked debt instruments and demonstrates a way to model them, focusing particularly on index-linked bonds.
In the same way a business would look to mitigate interest rates and currency risks, issuers and debtholders may want to shield against the risk of unexpected change in inflation rates. In this scenario, they have the option to use index-linked debt and swaps.
What are index-linked debt instruments?
Index-linked bonds are the most common instrument
The most straightforward way of shielding from inflation risk is through the use of index-linked debt, of which index-linked bonds are the most common instruments. Index-linked bonds are a specific category of bonds for which the coupons and/or principal payments are adjusted for a specific inflation index. In order to link debt to inflation, a commonly used index is the Consumer Price Index (CPI).
Index-linked swaps are another hedging mechanism
In the recent years, as international market conditions have changed in many countries making it harder to issue long-term index-linked bonds, certain companies have switched to another hedging mechanism: index-linked swaps. This way of mimicking inflation correlated debt entails borrowing nominal debt and swapping its fixed-rate exposure into an inflation-linked one.
What are the reasons for using index-linked debt?
Benefits for issuers
Regarding private issuers, companies which are subject to economic regulation often have part of their revenue growth contractually linked to inflation. Such entities can include energy or water utilities, airports and rail operators. Having a portion of their revenue stream correlated to inflation, it makes economic sense for them to also have a share of their debt linked to a general price index.
Using index-linked debt enables borrowers to shield against a low inflation or deflation scenario. In that case, the lower revenue (which is linked to inflation) is partly offset by a lower debt inflation adjustment, also referred to as accretion. This also generally allows them to benefit from a lower interest rate than traditional nominal debt. Reducing the cost of financing is often the main reason why governments, the primary issuers of index-linked bonds, offer investors real return debt instruments.
However, it increases the issuer’s refinancing burden as accretion accumulated over time results in a larger debt balance at maturity for index-linked bonds.
Benefits for debtholders
As for bondholders, index-linked debt protects them from the risk of inflation exceeding interest rate as this risk is transferred to the issuer. These instruments attract investors having long-term inflation indexed liabilities to match, such as pension funds.
Examples of modelling index-linked bonds
The examples below will help you better understand how index-linked bonds work and how to model them in a transparent, accurate and flexible way, using SMART best practice financial modelling methodology.
Example 1: Bullet repayment at maturity
Index-linked bonds are usually characterised by a single drawdown and bullet repayment at maturity. Periodically, an inflation adjustment is calculated by multiplying the current outstanding balance by the inflation rate for the relevant period. This accretion amount is then added to the current debt balance. At maturity, the borrower has to repay the initial debt drawn and the accretion accumulated over the bond life.
Accounting wise, the nominal balance (i.e. including accumulated inflation adjustments) is recorded on the balance sheet, while the accretion and nominal interest flow through profit and loss statement. It is important to note that accretion capitalised does not have an immediate cash flow impact as it only increases the liability that will have to be repaid at maturity.
Screenshot 1: Bullet repayment at maturity
Example 2: Amortising with linear repayment
In this slightly more complex example, we are going to model an amortising inflation-linked bond with linear repayment. Similarly to our previous example, an inflation adjustment is calculated in each period and added to the debt balance.
Regarding repayments, the real amounts in each period have to be adjusted, being multiplied by a cumulative inflation index. This is made easier by the creation of two accounts, real and nominal, as shown below. It can be noted that in the event of refinancing, the nominal balance would be the amount to refinance.
Screenshot 2: Amortising with linear repayment
Debt modelling resources
For more information regarding debt, you can refer to the following tutorials:
• Using goal seek to solve for maximum debt limit – for an example of debt sizing
• Debt Service Coverage Ratio – to understand this key project finance debt metric
• Debt repayment modelling – for the modelling of different repayment methods
Corality Training Academy - SMART Campus
Refer to the various training courses and free resources on our website to assist you in managing risks and building financial models with confidence.
Some of our related training courses for this topic include: