Index-linked gilts, or “Linkers”, are sold by the Debt Management Office (DMO) on behalf of the UK government and have both the coupon and the capital elements linked to inflation.
I’ll use the following Linker as an example: 1.25% of 2032 index-linked Gilt. If this were a conventional Gilt, this would pay the holder 1.25% interest (or coupon) of the issue price (or par) until 2032, when the redemption value would normally be the same as the issue price.
A Linker has both the coupon and redemption value linked to inflation, so using the above example, if it was issued at £100 and inflation was 5%, the redemption value increases to £105 and the coupon, which is paid twice yearly, would be £0.656 ((1.25% /2) * 1.05).
The measure of inflation used is the Retail Price Index, or RPI, which is typically 1% per annum more than the Consumer Price Index, or CPI. RPI is thought to be a better measure of the inflation that we actually experience living in the UK. With the main difference being that the CPI excludes house related costs, such as mortgages and council tax and the way that they get calculated. For those with a stronger understanding of maths, the CPI’s calculation is more geometric than the RPI.
A point to note about Linkers and contrary to often quoted opinion, index-linked bonds can mature below par if you suffer from deflation. Likewise, deflation can push the coupon to less than the original nominal amount. The price at which you can trade linkers is primarily driven by two factors: a) future expectations of inflation and (b) future expectations of interest rates. Investor demand, or lack of it, may have a short term effect on price as well.