What Are Dollar Bond Index-Linked Securities?
Dollar Bond Index-Linked Securities (Dollar BILS) are a type of debt instrument whose interest rate is determined at maturity by the return performance of a specified index over a given holding period. Due to this structure, Dollar BILS are categorized as zero-coupon floating rate debt.
Understanding Dollar Bond Index-Linked Securities (Dollar BILS)
Dollar BILS are typically useful for companies engaging in asset-liability matching. For example, if a company has a large liability due in six months, the company could invest its cash into dollar BILS now, rather than simply letting the cash sit idle for that time. The effective interest rate the company will receive from holding the dollar BILS will be equal to the return of the specified index during that time period, allowing the company to participate in any gains/losses the index incurs during that time period, but also still guaranteeing that the company will be able to liquidate its position for cash on the date it needs the funds to pay its liability.
Limitations of Dollar BILS
Dollar BILS and other index-linked securities carry a higher risk than traditional zero-coupon bonds and other fixed-income securities due to their reliance on the variable returns of an index to generate interest income and protect principal. Zero-coupon bonds are purchased at a deep discount to face value and earn interest as a result of appreciation to par at maturity. Investors in zero-coupon bonds are guaranteed to get back the face value of the bond at maturity but Dollar BILS do not carry such assurances. If these securities are linked to an equity index, such as the S&P 500, an investor could receive back less than their original principal should the value of the index be lower at maturity than at purchase.
Index-linked securities have various provisions that determine the interest an investor will receive. Some securities come with capital protection or a capital guarantee from the issuer, typically an investment bank or brokerage, that ensures return of principal at maturity. The participation rate offered by each security impacts the amount of interest received. Securities with a 100% participation rate will receive interest based on the full return of the underlying index while those with a participation rate of 80%, for instance, will receive 80% of the underlying index return.
Dollars BILS also differ from inflation-linked bonds which make periodic coupon payments that adjust with changes in the inflation rate, usually measured in the U.S. by the Consumer Price Index.