What Are Corporate Inflation-Linked Securities (CILS)?
The term corporate inflation-linked securities (CILS) refers to a series of security that seeks to mitigate the risks posed by inflation to a bond's rate of return. A bond or other similar security's returns drop when interest rates rise. This is mitigated by indexing the coupon rate to an inflationary gauge such as the consumer price index (CPI). The coupon rate is increased when inflation rises and the rate lowers during deflation.
- Corporate inflation-linked securities seek to mitigate the risks posed by inflation to a bond's rate of return by indexing the coupon rate to an inflationary gauge such as the consumer price index.
- Corporate inflation-linked securities also provide extra diversification, as they have a low correlation with other asset classes, and can reduce a bond portfolio's duration.
- When inflation is low, corporate inflation-linked securities produce below-average returns compared to traditional corporate bonds.
How Corporate Inflation-Linked Securities (CILS) Work
Inflation happens when the prices of goods and services increase, thereby reducing the purchasing power in the overall economy. This means that money can only go so far when prices rise. So when prices go up, the amount that one dollar—or any other unit of currency—is able to purchase drops. The effects of inflation are felt across the economy, from the purchasing power of consumers to the cost of borrowing as well as the returns on investments like bonds.
Fixed-income security returns are affected by interest rates and, therefore, inflation. During periods of inflation, governments raise interest rates. When interest rates rise, bond yields drop, lowering the amount of money that an investor can make. Some securities take inflation into account, helping investors mitigate the economic risks to their holdings.
Corporate inflation-linked securities—also referred to as inflation-linked bonds or linkers—are fixed-income securities that have a coupon rate that adjusts on a monthly basis to the prevailing inflation rate. The adjusting bond yields provide an income that responds rapidly to changes in inflation, thereby providing investors with some protection against inflation.
The majority of CILSs are issued by financial institutions. Because most of these issues are small, it is hard for retail investors to find CILS offerings, unless they work with a broker who deals with special types of bonds. Although it's important to note that these securities aren't as common as traditional fixed-income debt instruments. And while CILSs do provide investors with much higher nominal yields, they expose investors to the same credit risk, interest rate risk, and default risk as regular corporate bonds.
Corporate Inflation-Linked Securities (CILS) vs. Treasury Inflation-Protected Securities (TIPS)
Corporate inflation-linked securities are similar to government-issued Treasury inflation-protected securities (TIPS), whose bond principal also varies with inflation. They also provide extra diversification because they have a low correlation with other asset classes and can reduce a bond portfolio's interest-rate sensitivity or duration. That's because they are normally offered with maturities of five to 10 years. The trade-off is that when inflation is low, CILSs produce returns that are below average compared to traditional corporate bonds.
Corporate inflation-linked securities are just like Treasury inflation-protected securities that are offered by the government and whose bond principal also varies with inflation.
Example of Corporate Inflation-Linked Securities (CILS)
The coupon rate—which can have a ceiling and may only be partially floating—is typically aligned with an established measure of inflation, such as the CPI, and is updated monthly. For example, a corporate inflation-linked bond with a coupon rate of 5% and a par value of $1,000 pays the bondholder $50 per year in payments. If inflation were to rise to the level where the bondholders should receive $75 per year, then the coupon rate needs to increase to 7.5% (7.5% x $1,000 = $75). A CILS ensures that this rise would occur.