Index-Linked Debt and The Real Term Structure: New Estimates and Implications from the U.K.

Abstract

This paper provides a new analysis of index-linked debt in the U.K.. I begin by clarifying the theoretical links between the observed prices of conventional and index-linked debt, and the term structure of real interest rates. Based on this analysis, I then describe a new empirical methodology for analyzing index-linked bonds. This approach has significant advantages over existing methods. Moreover, when it is applied to the U.K. data, some striking findings emerge. In particular, there is strong evidence of large and time-varying inflation risk premia over a wide range of maturities. This finding implies that it is a good deal more difficult to accurately track movements in expected inflation from the behavior of conventional and index-linked bond prices that has often been thought. It also suggests that occasionally there are substantial fiscal benefits to be had from the issuance of index-linked rather that conventional debt.