How do inflation-linked bonds work?

In the context of high inflation, having an interest rate linked to the annual retail price index can be attractive. Corporate Finance Manager Richard O’Brien dives into inflation-linked interest and explains more.

Blog

- 9 June 2022

Empower Community Foundation is our tenth offer with an inflation linked interest rate, but what does it mean and how does it work?

In simple terms, the rate of inflation measures how much the prices of goods and services have risen over the last 12 months. One of the most common measures of inflation, the retail price index (RPI), currently stands at a staggering 11.1% for the year to 30 April 2022, so goods that cost £100 a year ago will on average cost £111.10 today.

How do our inflation-linked interest rate bonds work?

Over the last four years, we have raised £19 million in long-term debt for renewable energy projects with a bond term of 10 years or more. We know that high levels of inflation will make some investors cautious about committing their money for the long-term. That’s why the long-term renewable energy bonds we promote have interest linked to the inflation rate – but how does it work in practice?

Let’s take the example of a 10-year bond with a 4.5% interest rate linked to RPI. If you invested £1,000, in the first year you would receive £45 of interest. Assuming RPI was 4% a year each year for simplicity, the annual interest you receive would increase as follows:

Interest received:
Year 1 £45
Year 2 £46.80
Year 3 £48.67
Year 4 £50.62
Year 5 £52.64
Year 6 £54.75
Year 7 £56.94
Year 8 £59.22
Year 9 £61.59
Year 10 £64.05

You can see that there is a lag of a year between the increase in prices and the increase in interest rate. This is because the increase in interest rate is paid for by an increase in the income for the company.

The companies offering these bonds benefit from a government subsidy called the Feed-in-Tariff (FIT). The FIT provides small scale renewable energy generators with a guaranteed minimum price for electricity and a payment for the electricity that they generate. Both payments are increased by Ofgem – the energy sector regulator – each year based on the prior 12 months’ inflation rate.

What about capital?

The capital invested in the offers is not linked to inflation. The same amount of capital is paid back as the amount invested; it is only the interest rate that is linked to inflation. The capital invested in the community bonds is repaid in annual payments over the period of the bond, generally starting in the first couple of years of the bond term. In the case of Empower Community Foundation, our current bond offer, over 40% of the capital is forecast to be repaid in the first 10 years.

So what next?

High inflation makes investing decisions more complicated, as it becomes difficult to protect the spending power of your money. We don’t know how long inflation will stay high, but with an inflation-linked interest rate bond, there is some protection for investors’ returns from increasing prices.

If you’re interested in investing in organisations having a positive impact on people and planet, while earning a return that can offer some protection against inflation, why not take a look at the Empower Community Foundation bond offer, a charity with two operational 5MW solar parks.

You can invest from £50, either directly or in an Innovative Finance ISA, where any interest you receive will be free from tax. Investing comes with risk and ISA eligibility does not protect you against loss of capital. Read the offer document in full before deciding whether to invest.

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