Portfolios of conventional bonds may be structured so as to assure a nominal rate of return over a fixed time period. But such “immunized” portfolios can only lock in nominal returns and are limited to relatively short investment horizons. Indexed bonds—bonds whose payments are linked to a general price index, or any number of specific indexes—offer investors a way to lock in a real rate of return over an investment horizon of up to 20 years.
Whether or not an indexed bond is an appropriate immunization vehicle will depend upon the method used to link the bond’s payments to the underlying index. There are two basic methods of indexing. Changes in the real value of the bond’s principal may be offset by adjusting the periodic coupons. Alternatively, the principal may be adjusted to reflect changes in the underlying inflation index, while the coupons remain at a fixed percentage of a floating principal.
Bonds indexed by the latter method are the primary candidates for immunization, because their price sensitivity depends upon percentage changes in the real interest rate. A change in real rates will produce an instantaneous change in the present value of these bonds, which will be offset exactly by changes in real reinvestment returns on other indexed bonds over the remaining investment horizon.