How to model Index Linked Bonds
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The Financial Modelling Handbook is a collaborative guide designed to improve financial modeling practices, particularly for index-linked bonds. It provides detailed methodologies for calculating un-indexed and indexed interest, managing bond repayments, and understanding bond behavior in inflationary and deflationary environments. The handbook emphasizes the importance of collaboration to enhance accuracy and efficiency in financial modeling.
How to model Index Linked Bonds
- 2. Everything that is beautiful and noble is the product of reason and calculation. Charles Baudelaire
- 3. ABOUT THE FINANCIAL MODELLING HANDBOOK Financial modelling should be collaborative. Collaboration reduces error, speeds up development time and lowers cost. The Financial Modelling Handbook is a collaborative, crowd-sourced guide to building better financial models using the FAST Standard. www.financialmodellinghandbook.com/contribute
- 4. financialmodellinghandbook.com KOMAL Komal Aggarwal is a Financial Modeller at F1F9. She works mostly on projects in the oil & gas, mining and energy sectors. She likes doing adventurous sports. Financial Modelling HANDBOOK
- 5. An Index Linked Bond is one in which bond cash flows are calculated with reference to future inflation rates. As at 2008, government issued index linked bonds exceeded $1.5 trillion. This modelling guide explains how to model index linked bonds. financialmodellinghandbook.comFinancial Modelling DOWNLOAD THIS GUIDE AND THE ACCOMPANYING EXCEL EXAMPLE HANDBOOK INDEX LINKED BONDS How to model
- 6. financialmodellinghandbook.comFinancial Modelling HANDBOOK CALCULATING INTEREST The first part of the interest calculation looks at interest without inflation. This is done by applying a periodic interest rate to the un-indexed beginning balance of the bond. Formula in cell J14 = $F10 / $F11 * J12 * J13 Since the annual interest rate was quoted on a 30 / 360 basis, it has been converted to a periodic rate by dividing it by quarters in a year. 1 1
- 7. financialmodellinghandbook.comFinancial Modelling HANDBOOK UN-INDEXED BOND BALANCE The un-indexed repayments are calculated by multiplying the total bond amount by the repayment profile. Formula in cell J19 = $F17 * J18 2 3 The un-indexed bond balance is calculated using the bond balance at the start of forecast period; the calculated un-indexed repayments reduce the balance and are modelled in a cork screw. Formula in cell J27 = IF(J23 = 1, J22, J25 - J26) 2 3
- 8. financialmodellinghandbook.comFinancial Modelling HANDBOOK INDEXED INTEREST The un-indexed interest calculated at step 2 is now indexed, using an indexation factor specific to the bond (and documented in the bond documentation). This gives the indexed bond interest. Formula in cell J41 = J39 * J40 4 4
- 9. financialmodellinghandbook.comFinancial Modelling HANDBOOK REPAYMENTS AND BALANCE The indexed principal repayment and indexed bond balance are both calculated by multiplying the un-indexed amounts by a specific indexation factor. Formula in cell J47 = J45 * J46 Formula in cell J53 = J51 * J52 The index linked bond repayment is exported to the cash flow statement. 5 5
- 10. In an inflationary environment, the balance of an index linked bond increases even if there are neither cash movements nor further borrowings. Consequently, if there are bond repayments, the bond balance will be reduced by an amount that is less than the bond repayments. In a deflationary environment, the opposite will happen. Changes in the bond balance arising from inflation are charged through the income statement. INDEXATION
- 11. financialmodellinghandbook.comFinancial Modelling HANDBOOK INDEXATION (CONT.) The change in the index linked bond balance is the difference between current and previous period balances. Formula in cell R58 = (R56 - Q56) * R57 6 7 The indexation charge is calculated by summing the change in the index linked bond balance and the indexed repayments made. The indexation charge is the sum of repayments calculated in step 5 and the change in the index linked bond balance calculated in step 6. Formula in cell Q62 = SUM(Q60:Q61) 6 7
- 12. financialmodellinghandbook.comFinancial Modelling HANDBOOK INDEX LINKED BOND BALANCE The indexation charge calculated in step 7 is added to the bond balance, while the indexed repayments are deducted from the bond balance. Formula in cell J72 = IF(J67 = 1, J66, J69 + J70 - J71) The balance for an index linked bond can be calculated using a standard cork screw. 8 8