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In Finance, what are Linkers?

John Lister
John Lister

Linkers are a type of bond where the interest payment is linked to inflation. They are formally known as inflation-indexed bonds. The idea of the bond is that the investor knows what the return will be in real terms and does not have to worry about the effects of inflation. In theory, this lack of risk should mean the return on offer is slightly lower for linkers than with other bonds.

A bond is a type of debt product by which an investor pays money to a company to buy a bond. On the bond's fixed expiration date, the investor gets back the money he originally paid, plus an interest payment known as a coupon. In most cases the bond can be bought and sold on the open market until it expires, so the person who cashes it in will often not be the original investor.

Woman holding a book
Woman holding a book

Usually, a bond simply pays a fixed rate of interest. For example, an investor may buy a $100 United States Dollars (USD) five-year bond at a 20% coupon. This means the investor will get back $120 at the end of the five-year period. In some cases, there will be regular payments throughout the bond's lifespan. A $100 USD five-year bond with an annual 5% coupon will pay $5 per year, plus return the original $100 USD at the end of the five years.

The danger is that some or all of the return will be eaten up by inflation. In the first example above, inflation may mean that average goods costing $100 at the start of the five-year period cost $110 USD at the end of the period. This would mean that although the investor has made a $20 USD profit, he is only better off by $10 USD in real terms.

Linkers tackle this by adjusting the returns for inflation. The precise method used varies with different linkers, and can involve changing either the principal used to calculate the final payment, the interest rate used to calculate the payment, or both. The general idea is always the same: the investor gets enough money to get back the guaranteed return once the effects of inflation are taken into account.

To take the latter example above, each individual payment could be adjusted for inflation. For example, at the end of the first year, the investor would get a payment combining the 5% coupon rate with an extra amount equal to the coupon rate multiplied by the rate of inflation. If the rate of inflation was 3%, the investor would get back 5% plus 0.15%, totaling 5.15% or $5.15 USD. This is the amount needed to make sure the investor gets back the promised 5% in real terms.

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