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Whether you’re saving, investing, or both, you need to take the cost of inflation into account. When inflation outpaces interest rates, it means that you’re losing money. Index linked savings accounts, bonds, and certificates help address this issue – but what does index linked mean, and how does it work? We’ll cover the basics below.
What does index linked mean?
To better understand index linking, it’s first important to give a quick definition of inflation. Inflation simply refers to the collective price rise in a basket of goods or services. Index linked means that a financial product is tied to this inflation. For example, an index linked pension increases annually to match the rise of inflation. Index linked bonds, pensions, or policies increase and decrease according to the rise and fall of prices. These price fluctuations are measured using tools such as the Consumer Price Index (CPI) within the UK.
How do index linked bonds work?
When you purchase a bond, it comes with a fixed interest rate attached. Throughout the life of the bond, you’ll receive interest payments on a regular basis to represent the rate of return. Yet as inflation increases over time, this can have a detrimental impact on the bond’s value.
Index linked bonds are a common investment vehicle to solve this problem. Interest payments will depend on the price movements of a specific price index, such as the CPI. This protects investors when inflation outstrips the original interest payment rate, ensuring the bondholder receives a real rate of return. This eliminates the uncertainty or volatility created by inflation rates.
Understanding index linked gilts
In the UK, bonds are more frequently called gilts. This country was one of the first economies to use this tactic by issuing the first index linked gilt back in 1981. In comparison to conventional gilts, index linked gilts are adjusted according to movements in the General Index of Retail Prices (RPI). These adjustments apply not only to the gilt’s interest payments, but also to its principal payment to ensure the bondholder receives a real rate of return. When you purchase a gilt from a bank or other provider, you can use the institution’s index linked calculator to work out cash flows.
Understanding index linked savings accounts
In addition to gilts or bonds, index linking is applied to certain savings accounts within the UK. When you open a savings account, you probably shop around to find an advantageous interest rate to watch your lump sum of money grow. However, it’s not uncommon for inflation to outpace this interest rate – meaning you run the risk of losing money. An index linked savings account is like a fixed rate account in that your money is set aside to grow in interest. The only difference is that the percentage changes according to inflation. To guard against deflation, look for an account that offers a fixed percentage on top of the index linked percentage.
Understanding index linked savings certificates
The UK’s National Savings and Investments bank offers inflation linked bonds called index linked savings certificates. These are issued for typical lengths between two and five years with interest payments linked to the CPI. Although you can cash in these savings certificates at any point, you won’t benefit from the CPI indexing until at least one year has passed. One benefit of index linked savings certificates is that they’re exempt from UK income tax. They’re also backed by the Treasury for added security.
The bottom line
Could index linked gilts, savings certificates, or other vehicles be a good investment for you? It depends. Be sure to look at the fine print carefully, particularly when it comes to savings accounts. Some will match inflation rates but won’t offer a very favourable interest rate beyond this. Deflation is also an issue to be aware of, so look for accounts that include a guaranteed fixed price if inflation goes backwards. Find out what type of index linked calculator the institution uses, as well as which price index it chooses to follow. This will give you a more well-rounded view of your financial prospects.
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