Inflation Linked Bonds: Heightening Terrains of Sharia Compliance

What is Inflation linked bonds?

An index or inflation linked bond is a bond which has its coupon payments adjusted for inflation by linking the payments to some inflation indicator, such as the Consumer Price Index (CPI) or the Retail Price Index (RPI). These interest-bearing investments typically pay the investors a yield plus accrued inflation, providing a hedge against inflation. The payment and principal amount are calculated in real terms, not nominal numbers. One can think of the CPI as the exchange rate that converts the return on a bond investment to real return.

An inflation indexed bond claims to protect both investors and issuers from the uncertainty of inflation over the life of the bond. Like conventional bonds, indexed bonds pay interest at fixed intervals and return the principal at maturity. The fundamental difference is that while conventional bonds make payments that are fixed in nominal dollars (and thus are called nominal bonds), indexed bonds make payments that are fixed in real terms (and thus are called real bonds).

This type of bond is valuable to investors because the real value of the bond is known from purchase and the risk involved with uncertainty is eliminated. These bonds are also less volatile than nominal bonds and claim to help investors to maintain their purchasing power.

Sharia Perspective:

Since index linked bonds are debt instruments which pay investors interest, the AAOIFI Shariah Standard No.21 expounds on the rulings of these types of bonds:

“The issuance of all kinds of bonds is prohibited when these bonds include stipulations for the return of the amount of loan and excess in any form, whether such excess is paid at the time of the satisfaction of the principal amount of loan, is paid in monthly or yearly instalments or in another manner and whether this excess represents a percentage of the value of the bond, as in the case with most types of bonds, or a part of it, as is the case with zero-coupon bonds. Likewise, prize bonds are also prohibited. This applies irrespective of the bonds being private, public or governmental.”

Therefore, index or inflation linked bonds are subject to Riba and not Shariah compliant. In addition to the above, the AAOIFI Shariah Standard No.21 mentions in respect to trading bonds:

“Trading in bonds, both sale and purchase, is prohibited and so is their pledging and endorsement and so on.”

This is another issue with bonds. These debt instruments are traded in a number of ways; where the sale price is different to the face value. This again fails Shariah compliance as it results in Riba (interest) and the trading of prohibited debt.

Download to learn the alternatives that Sharia provide, where the rental payments are linked to the inflation index.