Index linked gilts are the ultimate in safe securities for British investors. Not only are they government backed (enough, in itself, to classify investments as risk free) but all payments are linked to inflation, which means that even the risk of inflation eating away at the real value of the investment is eliminated. This is an investment that is well suited to investors who need to guarantee their income and do not need high returns.
When looking at the prices of index linked gilts, note that the clean price excludes both the accrued interest (as for any bond) and the adjustment made for inflation to the return of the principal.
The coupon payment is calculated using the inflation index at a date some months previously: three months for index linked gilts issued since 1995.
This means that the inflation index for payments in the near future (whether dividend or principal) may be known, but others will have to be estimated.
This is conceptually fairly simple, but the implementation is made a little tedious by the need to interpolate the inflation index for a particular date. The reference RPI for a date is:
- if the date is the first of a month, the published RPI for that month.
- if the date is not the first of the month, then it is interpolated using the RPI for that month, and the RPI for the next month.
The formula for interpolation is:
RefRPIDate = RPIM + ((t - 1) ÷ D)(RPIM+1 - RPIM)
where:
RefRPIDate is the RPI for a payment date,
RPIM is the RPI for the first day in the month,
RPIM+1 is the RPI for the first day of the following month,
t is the day number in the month, and,
D is the number of days in the month.
Each payment is multiplied by the index ratio, which is:
RefRPIDate ÷ RefRPIIssueDate