Baer, Werner, and Paul Beckerman, 1980, “The Trouble with Index-Linking: Reflections on the Recent Brazilian Experience,” World Development, Vol. 8.
Bank of England, 1995, Overview Papers, for conference “The U.K. Index-Linked Gilt-Edged Market: Future Development,” London, September 14-15.
Barro, Robert, 1995, “Optimal Debt Management,” paper presented at Bank of England Conference, “The U.K. Index-Linked Gilt-Edged Market: Future Development,” London, September 14-15.
Bodie, Zvi, Alex Kane and Robert McDonald, 1986, “Risk and Required Returns on Debt and Equity,” in Benjamin M. Friedman, ed., Financing Corporate Capital Formation, (National Bureau of Economic Research).
Brash, Donald, 1995, “Address by the Governor of the Reserve Bank of New Zealand to the New Zealand Society of Actuaries,” (Wellington, December 4).
Calvo, Guillermo A., and Pablo Guidotti, 1989, “Indexation and Maturity of Government Bonds: A Simple Model,” IMF Working Paper 89/46 (Washington: International Monetary Fund).
del Canto, Jorge, 1982, “Impact of Inflation on the Development of Capital Markets in Argentina and Brazil,” in Capital Markets Under Inflation, Bruck, Nicholas, ed., (New York: Praeger Scientific).
Deacon, Mark and Andrew Derry, 1994, “Deriving Estimates of Inflation Expectations from the Prices of U.K. Government Bonds,” Bank of England Working Paper Series No. 23 (July).
Emerson, Michael, 1983, “A View of Current European Indexation Experiences,” in Inflation, Debt, and Indexation, Dornbusch, Rudiger and Mario Henrique Simonsen, eds., (Cambridge, Mass.: MIT Press).
Fischer, Stanley, (1983a), “Welfare Aspects of Government Issue of Indexed Bonds,” in Inflation, Debt, and Indexation, Dornbusch, Rudiger and Mario Henrique Simonsen, eds., (Cambridge, Mass.: MIT Press).
Fischer, Stanley, (1983b), “On the Nonexistence of Privately Issued Index Bonds in the U.S. Capital Market,” in Inflation, Debt, and Indexation, Dornbusch, Rudiger and Mario Henrique Simonsen, eds., (Cambridge, Mass.: MIT Press).
de Fontenay, Patrick, Gian Maria Milesi-Ferretti and Huw Pill, 1995, “The Role of Foreign Currency Debt in Public Debt Management,” IMF Working Paper 95/21 (Washington: International Monetary Fund).
Friedman, Milton, 1974, “Monetary Correction,” in Essays on Inflation and Indexation, The American Enterprise Institute for Public Policy research (Washington).
Giersch, Herbert, 1974, “Index Clause and the Fight Against Inflation,” in Essays on Inflation and Indexation, The American Enterprise Institute for Public Policy research (Washington).
Gunnarsson, Birgir Ísleifur, Governor and Chairman of the Board of Governors of the Central Bank of Iceland, 1995, “The Icelandic Capital Market: Characteristics and Possibilities,” address to The Nordic Investment Conference (Helsinki: September 26-27).
Hetzel, Robert L., 1992, “Indexed Bonds as an Aid to Monetary Policy,” Economic Review, Federal Reserve Bank of Richmonds, Vol. 78/1 (January/February).
Huberman, Gur and G. William Schwert, 1985, “Information Aggregation, Inflation, and the Pricing of Indexed Bonds,” Journal of Political Economy, Vol. 93, No. 1.
Humphrey, Thomas M., 1974, “The Concept of Indexation in the History of Economic Thought,” Economic Review, Federal Reserve Bank of Richmond, (November/December).
Kafka, Alexandre, 1974, “Indexing for Inflation in Brazil,” in Essays on Inflation and Indexation, The American Enterprise Institute for Public Policy Research (Washington).
Kapur, Basant K., 1982, “Problems of Indexation in Financially Liberalized Less Developed Economies,” World Development, Vol. 10, No. 3.
Levhari, David, 1983, “The Effects of Government Intermediation in the Indexed Bonds Market on Consumer Behavior,” in Inflation, Debt, and Indexation, Dornbusch, Rudiger and Mario Henrique Simonsen, eds., (Cambridge, Mass: MIT Press).
Liviatan, Nissan and David Levhari, 1977, “Risk and the Theory of Indexed Bonds,” American Economic Review, Vol. 67, No. 3 (June).
Mahony, Stephen and Anna D’Andrea, eds., 1995, The 1995 International Guide to Government Securities Markets and Derivatives (London: IFR).
Mendoza, Enrique G., 1992, “Fisherian Transmission and Efficient Arbitrage Under Partial Financial Indexation: The Case of Chile,” Staff Papers, International Monetary Fund, Vol. 39, No. 1.
Mendoza, Enrique G., and Fernando Ferández, 1994, “Monetary Transmission and Financial Indexation: Evidence from the Chilean Economy,” IMF Paper on Policy Analysis and Assessment 94/17 (Washington: International Monetary Fund).
Munnell, Alicia and Joseph B. Grolnic, 1986, “Should the U.S. Government Issue Index Bonds?” New England Economic Review, Federal Reserve Bank of New England (September/October).
Penati, Alessandro, George Pennacchi, and Silverio Foresi, 1995, “Reducing the Cost of Government Debt: the Italian Experience and the Role of the Indexed Bonds,” (mimeo).
Samuelson, Larry, 1988, “On the Effects of Indexed Bonds in Developing Countries,” Oxford Economic Papers, Vol. 40, No. 1 (March).
Shen, Pu, 1995, “Benefits and Limitations of Inflation Indexed Treasury Bonds,” Economic Review, Federal Reserve Bank of Kansas City, Vol. 80, No. 3 (Third Quarter).
Simonsen, Mario Henrique, 1983, “Indexation: Current Theory and the Brazilian Experience,” in Inflation, Debt, and Indexation, Dornbusch, Rudiger and Mario Henrique Simonsen, eds., (Cambridge, Mass.: MIT Press).
Stiglitz, J. E., 1983, “Indexation, Price Rigidities, and Optimal Monetary Policies,” in Inflation, Debt, and Indexation, Dornbusch, Rudiger and Mario Henrique Simonsen, eds., (Cambridge, Mass.: MIT Press).
Tobin, James, 1963, “An Essay on the Principles of Debt Management,” in Fiscal and Debt Management Policies (Englewood Cliffs: Prentice Hall).
Veneroso, Frank, 1982, “Systems of Indexation and their Impact on Capital Markets,” in Capital Markets Under Inflation, Bruck Nicholas, ed., (New York: Praeger Scientific).
Helpful comments were received from Tomás J.T. Baliño, George Iden, Alain Ize, Bernard Laurens, José S. Lizondo, Axel Palmason, and Fabio Scacciavillani.
The respective ex-ante returns are certain for zero coupon bonds, on which there is no reinvestment risk, but may vary on coupon bonds owing to the uncertainty of reinvestment rates for the bonds’ interim cash flows.
Where markets are complete and efficient, with no distorting taxes, the paths of debt and taxes can be shown to be irrelevant, following the debt neutrality theorems of Barro 1974 and others. Here it is assumed that debt management is not neutral, either because markets are incomplete, taxes distort, markets are segmented, etc., so that choices do matter.
Dampening real inventory swings would subdue booms and busts in business cycles, as discussed below.
This thought was taken up by Donald Brash, New Zealand Reserve Bank Governor, in a speech extolling the merits of New Zealand’s indexed bond program. He stated, “I am convinced that issuing inflation-adjusted bonds has great benefit to the ordinary New Zealand saver. To put this in context, it is worth recalling that inflation is a process, sanctioned by the Government and the central bank, which enables borrowers to steal from savers… Issuing inflation-adjusted bonds is the best way of saying that, even if some future Government decides to sanction theft-through-inflation, the present Government does not approve of such theft, and is willing to provide a means by which savers can protect themselves against it.” See Brash (1995).
A rate view can also be taken by altering the portfolio duration: shortening it when rates are expected to rise, lengthening it when they are expected to fall.
Again, the comments of the New Zealand Reserve Bank Governor are pertinent. He stated that while the Australian and U.K. governments were borrowing at real rates of 3.8 and 5.5 percent respectively through indexed bonds, “We, on the other hand, have been borrowing at real yields of 7 to 8 1/2 percent, if we can assume that the underlying inflation will average 1 percent over the life of the bond. Therein lies the rub: the fact that we have been obliged to borrow at 9 percent in nominal terms very strongly suggests that most people, here and abroad, do not believe that our inflation will average 1 percent over the next decade… So this Government, and today’s taxpayers, pay a penalty. By issuing inflation-adjusted bonds, the Government avoids paying this penalty. Instead of borrowing at 7 percent in real terms, it borrows at a rate which, presumably, would be akin to the real interest rate at which Australia borrows using inflation-adjusted bonds, less than 6 percent.” See Brash (1995). The New Zealand Reserve Bank has an explicit inflation target of between 0 and 2 percent measured quarterly.
This is the essence of theorems of debt neutrality, as for example in Levhari (1983): the government must service its liabilities, imposing costs on the public that offset the benefits of the program.
This is the thrust of Baer and Beckerman’s (1980) criticism of Brazilian indexation: “the introduction of index-linking in any particular financial sector has always entailed a shift in the burden of inflation risk from one side of the market to the other. In many cases, the parties to whom the risk was shifted proved as reluctant to bear it as the parties from whom the risk was shifted; and so, in one way or another, the risk was finally shifted to the government (e.g., the index-linked government bonds), to a government dependency (e.g., the Housing Finance System), or to the banking system (e.g., the agricultural credit system).”
Penati et al. (1995) model the inflation risk premium in Sweden, however, and find a low inflation scenario results in higher estimates of the inflation risk premium than a high inflation scenario.
The authors cite several reasons for the issue failure: it was too small to be liquid, the indexation had a one year lag, and the price index was unfamiliar to investors.
Their explanation was that the shape of the yield curve reflects expected movements in inflation expectations and risk premia, so that higher inflation expectations explain a greater proportion of market prices, therefore risk premia must explain a lower proportion.
Shen (1995) points out the possibility of a negative risk premium, because issuers are also exposed to inflation risk. If issuers are more inflation risk averse than lenders, then they may require a premium for issuing such bonds. In this case the value of an option to the issuer would exceed the value of an option to investors. However, it may be plausible to assume that if governments are not inflation-risk neutral, they are at least less risk averse than lenders, and the risk premium is likely positive.
Benchmarks issues are recently issued current coupon bonds at specified maturities in which secondary market trading tends to concentrate. Issuers can increase the liquidity of these issues by adding to their size by subsequent offerings of bonds with the same coupons, features and maturity dates. Because of the high level of trading activity in these issues, the liquidity premium by definition is minimal, or zero.
This may result from a higher inflation outcome from stronger economic activity, combined with a progressive income tax regime. However, in countries facing very high rates of inflation, lags in tax collections may result in lower real government revenues (the so-called “Tanzi” effect).
The budget position is complicated by the tax treatment of indexed bonds, discussed further in Section IV.
If inflation expectations were shown to be systematically biased, which may be unlikely, then the yield gap would still provide the authorities with useful information, after adjusting by the amount of the bias.
Part of the inflation compensation on the type of indexed bond issued in the U.K. is through adjustments to the principal, unlike on nominal bonds where compensation for expected inflation is through the coupon rates.
However, problems with the long (8-month) index lag, lack of short-maturity IGs, and tax distortions, cause them to consider the measure for yields only beyond two years (see Bank of England (September 14/15, 1995)).
France issued bonds indexed to the price of gold in 1946. These bonds were refinanced on maturity in 1973, but with the skyrocketing price of gold during the 1970s, the bonds proved very costly. The bonds have since matured.
In any case, indexation would be expected to produce only a one-time effect on the savings rate.
Dummy variables were included for wages, taxes, social security, investment and government bonds. Values were assigned based on the author’s judgment, without any attempt to quantify the extent of indexation of the parameter in each country at the time.
The only variable which did show some statistical significance was bond indexing, when measured after a lag of four years. However, while the author surmised “perhaps bond indexation in particular is introduced in countries that have decided not to pursue counter-inflationary policies,” he dismissed this as a possible statistical aberration and suggested no great weight should be placed on this result due to the long adjustment period.
Of course, were the central bank able and nimble enough to ensure price stability, there would be no need for indexed bonds, so there remains this nuance of contradiction.
However, other steps have been taken to strengthen central bank independence, most notably through closing the overdraft facility to government in 1992-93, the auctioning of government debt, and moving to indirect instruments of monetary control.
Capital controls prevented Israeli residents from holding foreign currency deposits, however immigrants were exempted, as were business and commercial accounts.
The ex-post correction was reduced from a quarterly to a monthly basis in 1984, but under the circumstances of accelerating inflation was insufficient to prevent real rates from declining. The problem of index lags is discussed in Section IV, below.
TR is calculated daily as the average interest rate on 30-day CDs of the main financial institutions over the previous 3 days, minus 1.02 percent which is intended to account for taxes and real interest rate components.
Although here too the markets may have influenced the issuer’s hand; for example, accelerating inflation (the U.K.), or burgeoning deficits (Canada), constrained the debt manager’s room for maneuver at the time.
Bonds indexed to real commodities, such as gold or oil, have been rare, and are not discussed in this paper.
This behavior indicates governments are not risk-neutral.
The Reserve Bank Governor’s remarks (Brash, 1995) illustrate this point: “Today, we are not opposed to the Government’s intention to repay all net foreign-currency debt, in part because interest rates in New Zealand are now much closer to those in major overseas markets but mainly because Government has also announced its willingness to issue an inflation-adjusted bond. Why should Government’s willingness to issue an inflation-adjusted bond be relevant to Government’s intention to repay foreign debt? Because, from the point of view of both Government’s debt management and monetary policy credibility, foreign currency debt and inflation-adjusted bonds have very similar properties. Foreign-currency debt can not be inflated away by the New Zealand Government. New Zealand dollar debt can be inflated away by the New Zealand Government, and it is precisely because of this risk that we are currently having to pay such high real interest rates to borrow money in the form of conventional bonds. Repaying all foreign-currency debt without providing the option for investors to buy inflation-adjusted bonds would inevitably raise questions in the minds of actual and potential buyers of New Zealand dollar conventional bonds about the risk of expropriation-by-inflation, and thus contribute to higher long-tern interest rates and reduced credibility of the commitment to maintain low inflation.”
Even in Brazil, where indexing became near universal over the past three decades, corporations issued almost no inflation-indexed bonds, nor for that matter any kind of domestic currency debenture, preferring to tap foreign currency markets.
Although he observed that an increase in variance of inflation at the time the article was written “may well lead to the emergence of privately issued indexed bonds.”
The RPI has been criticized because it includes the cost of mortgage interest payments (at nominal rates), and therefore introduces an element of double counting when used as the index for bonds.
See Huberman and Schwert (1985) for a discussion of the way inflation data is incorporated into indexed bond prices. Using Israeli data, they conclude that bond prices reflect about 85 percent of the new information about inflation as it occurs, while the remaining 15 percent is incorporated on the day following the announcement of the CPI, 15 days after the end of the inflation sampling period. Bond markets are thus fairly efficient in incorporating inflation data into current prices.
The change in legislation was part of a broader package of reforms that include, inter alia, measures to gradually decrease the scope of financial indexation in Iceland.
The formula was set at [0.8 * (wholesale price index) + 0.2 * 15%] in 1976. The wholesale price index was a three-month moving average, lagged two months. Bondholders would lose whenever actual inflation exceeded the 15 percent per annum “prefixed” adjustment, and came out ahead when it was less. See Jud (1978) or Baer and Beckerman (1980) for further discussion of this and other formula changes.
In Brazil, bonds were remunerated at 6 percent plus indexation during the freeze.
Duration is the weighted average term to maturity of a bond or portfolio, where the weights are the present values of all cash flows (coupons and principal). It is a superior measure of interest rate risk than maturity alone, although duration cannot capture certain risks such as non-parallel shifts in the yield curve, and thus is itself an imperfect measure.
The fact that yields-to-maturity on two clearly different bonds are the same highlights the deficiency of this measure.
In the U.K., the financial press reports real rates of return on IGs on the basis of different assumed future inflation rates, such as 3, 5, and 10 percent, to deal with this index lag problem.
In this case, the three month lag is to compensate for the lag in producing the CPI (about three weeks), plus a month to calculate the next month’s index value to allow interpolation during the month, and another month to cover possible delays in the CPI release.
There is, however, a trade-off between market segmentation and providing large, fungible benchmark issues which may lower the issuer’s cost of funding by increasing market liquidity.
Zeros can be offered directly in market by the issuers, or can be created by market intermediaries by “stripping” coupon bonds (or through the reverse process, reconstituting coupon bonds by recombining strips). The strips market is greatly facilitated by book-entry systems, such as STRIPS in the U.S., or CDS in Canada. The advantage of letting the market handle it is that virtually any cash flow can be created, to custom tailor asset matches against investor liabilities.
For example, consider an indexed bond guaranteed to yield a 4 percent real return. At 1 percent inflation, the pre-tax nominal return rises to 5 percent (= 4 + 1). At a flat 30 percent tax rate, the after-tax nominal return is 3.5 percent [= 5 percent * (1 - 0.3)], and the after-tax real return is 2.5 percent (= 3.5 - 1.0). At 5 percent inflation, the pre-tax return rises to 9 percent (= 4 + 5), the after-tax nominal return to 6.3 percent [= 9.0 percent * (1 - .3)], but the after-tax real return is only 1.3 percent (= 6.3 - 5.0).
In the example in the previous footnote, the nominal bond is priced to yield 5 percent when the real rate is 4 percent and the inflation expectation is 1 percent. It will pay the same after-tax nominal and real returns as the indexed bond (3.5 percent and 2.5 percent, respectively) if the expectation is realized. However, if inflation unexpectedly moves to the higher rate of 5 percent, the after-tax nominal return on the nominal bond remains at 3.5 percent, and the real return declines to -1.5 percent (= 3.5 - 5.0). Therefore, the decline in the after-tax real yield for the nominal bond is 4.0 percentage points [= 2.5 - (-1.5)], or the full amount of the unexpected inflation (= 5 - 1). In contrast, the decline in real after-tax yield for the indexed bond was only 1.2 percentage points (= 2.5 - 1.3), which equals the product of the full inflation change (4 percent) times the tax rate (.3).
When the U.K. first launched IGs in 1981, ownership was restricted to non-taxable accounts (“gross funds”). This allowed authorities to leave unresolved issues of tax treatment of capital revaluations on indexed bonds. It also provided an opportunity for a limited “test market” of the bonds. Subsequent tax changes were designed to bring the treatment of indexed bonds in line with conventional bonds, allowing IGs to tap the broader taxable market for debt securities. See Munnell and Grolnic 1986 for a discussion.
As noted above, the evidence is that liquidity in the Canadian RRB, Australian TIB and U.K. IG markets is lower than for conventional nominal government bonds.
The latest tax reforms are designed to foster development of a Gilt strips market (strips, or zero coupon bonds, are affected most by the application of the income tax accrual rules).
While ownership of RRBs is unrestricted, the prospectus warns: “Accrued Inflation Compensation for a series of Bonds must be included in a Bondowner’s income…, notwithstanding that payment in respect thereof will not be made until Maturity for such series. Taxable Bondowners should have regard to their respective tax positions, particularly in the event that the Coupon Interest received at any relevant time is insufficient to cover the income taxes exigible on all interest required to be included in income in connection with the Bonds.“
New Zealand is an exception, having moved to an accrual basis for the public accounts.
It is interesting to note that four of the five industrial countries to have adopted formal inflation targets—Canada, New Zealand, Sweden, and the U.K.—another formalized mechanism to promote inflation-fighting credibility, have also introduced indexed bonds.