Variable Unlinked Track — It Is Affected by the Consumer Price Index
This article is about the variable unlinked loan and the false sense of security it creates. The subject is complex and takes some real understanding, which is why we've given it its own discussion.
Across the many mortgage mixture analyses we run, we keep running into the same thing: clients who built a mixture free of CPI linkage — usually a combination of a fixed unlinked track, a prime-linked track, and a variable unlinked track — and are surprised to find that the expected monthly payment rises over the years. "How can that be?" they ask. "We deliberately chose a mixture with no indexation."
The short answer: a variable unlinked loan is, in fact, affected by the Consumer Price Index (CPI) — just indirectly. Here's the full explanation.
Why Does a "Non-CPI-Linked" Loan Still Get Affected by Inflation?
The indirect link between inflation and the mortgage interest rate
Even a "non-CPI-linked" loan is affected by inflation — indirectly, through its impact on bond yields.
The difference: In a CPI-linked loan the impact is direct and immediate. In a non-CPI-linked loan the impact is indirect and surfaces at the next interest rate adjustment.
The connection between variable-rate loans and the capital market
In the next few paragraphs we'll explain what a bond is, how the variable-rate loan's update mechanism works, the difference between a real and a nominal bond, how it all connects to CPI linkage, and more. There's a lot of capital-market detail here, because the bonds traded in the capital market are the basis for pricing some of the mortgage loan tracks. If you start to lose focus, you can skip to the next section — but the explanations in the section after that build on everything written here.
A variable unlinked loan is a loan that every bank offers and lets you include in your mortgage mixture. The bank picks an objective economic parameter — one that's known and accessible to everyone and that the bank can't influence. This is the loan's "anchor."
The most common objective variable in mortgages is the yield on Israeli government bonds.
You get to choose how often the interest rate updates. The higher the frequency, the faster the rate-update cycle.
For this discussion, let's assume a variable unlinked loan that updates every five years. Every full five years from the date you took out the loan, the interest rate is updated in line with the change in the "anchor" rate. If, for example, the anchor yield has risen 1% by the update date compared with five years earlier, your loan's interest rate rises by 1% too.
📚Bonds crash course (click to expand)
A bond is a loan — money, in plain terms — that we grant to another entity for a known period of time, and in return that entity pays us interest on the money it received from us. In the case of our anchor (the five-year nominal zero-coupon bond yield of the Israeli Government), we're lending to the State of Israel. As a rule, interest is paid each year until the date we agreed the money would come back to us. That date is called the maturity date. To repeat: on the maturity date we get all our money back.
Let's illustrate with a practical example.
We'll use the Israeli government bond known as Government Shekel 0347, bond number 1140193. Looking at the data for this bond tells us the following: its maturity date is 31/3/2047 and it carries a coupon of 3.75 agorot. At issue, we could buy one such bond for 100 agorot — that is, one NIS. Each year from now until the maturity date, we receive the coupon of 3.75 agorot for each bond we hold. The payment date each year is 31.3. On 31.3.2047 we receive the coupon — 3.75 agorot, as a reminder — plus all our money back: 100 agorot.
Bond Lifecycle
On 23/5/2019, the bond's trading price in the capital market was 115.68 agorot. So had you bought the bond that day, you'd have paid 115.68 agorot per bond. It's worth stressing that on the maturity date you'd get only 100 agorot back. In other words, you're relying on the interest payments of 3.75 agorot per year for this investment to come out profitable in the end. The yield to maturity (YTM) is the annual return you'd receive if you held the bond until maturity.
The annual return is calculated using the Internal Rate of Return (IRR). As of 23/5/2019, the yield to maturity (YTM) on that bond was 2.95%. The yield to maturity (YTM) is lower than the coupon actually paid (3.75 agorot) because the bond price is above 100 agorot.
📚Enrichment paragraph — regular bond vs zero-coupon bond
Unlike the bond we just described, a zero-coupon bond is a bond that pays no coupon during the years. Only on the maturity date does a zero-coupon bond pay an enlarged coupon designed to compensate you for the fact that you put money in now and saw no return on your investment for many long years.
Comparison: Regular Bond vs. Zero-Coupon Bond
Regular Bond (with coupons)
Annual coupon payments + principal at maturity
Zero-Coupon Bond (no coupons)
No payments until maturity date
Payment Summary
Inflation — the difference between real and nominal
A nominal bond is a bond that doesn't compensate its holder for changes in the Consumer Price Index (CPI). You absorb the inflation — that is, inflation "eats into" or erodes part of your profit. If, for example, the bond paid you 3.75 agorot but inflation ran 1.75% this year, then in practice your money earned only about 2%, because inflation ate away 1.75% of its value.
With a nominal bond, all the inflation risk is rolled onto you. So you need to demand and receive higher compensation in the form of a higher interest rate. Accordingly, the rates on unlinked bonds (and by extension, unlinked mortgage tracks) are always higher than the rates on CPI-linked bonds (and by extension, CPI-linked mortgage tracks).
A real bond is a bond that does compensate its holder for changes in the Consumer Price Index (CPI). You're compensated for inflation — that is, on the interest payment date you get an extra payment to cover the inflation. So if you received 2% interest each year and inflation ran 1.75%, you'd get roughly 3.75% back — that is, compensation for the inflation.
The Effect of Inflation: Nominal vs. Real
At an inflation rate of 2% per year, after 5 years:
Cumulative inflation is 10.4%
💸 Nominal Bond
Erosion of 9.4 ₪ in purchasing power
🛡️ Real Bond (CPI-linked)
Compensation of +10.4 ₪ for inflation
Key Takeaway: With a nominal bond, you absorb inflation — the money you receive is worth less in real purchasing-power terms. With a real (CPI-linked) bond, you are compensated for inflation and real value is preserved.
Now let's talk about the bond update every five years. For simplicity, we'll illustrate it with a regular bond. Assume the bond we discussed, Government Shekel 0347, is our anchor, and that as we near the maturity date, the bond price falls back toward 100 NIS. Remember we said that as of 23.5.2019 the bond's value was 115.68 agorot? Five years later (measured from 22/5/2024), as a result of the war, the bond's value plunged to 77.93 agorot, and the yield to maturity (YTM) was 5.5%.
In this example, the interest rate rose because of changes in the pricing of the anchor — that is, the change in its cost in the capital market. Now we come to the important point: the bond price, and with it the change in the anchor, can also shift because of inflation.
As a result, the rate on the variable unlinked track rises by the difference between 2.95% and 5.5% — that is, by 2.55%.
What is the risk in a variable-rate track
Now let's see how a variable-rate loan that updates every five years and is unlinked to the CPI is, in practice, affected by the Consumer Price Index. As explained above, when you choose a variable unlinked loan, the inflation risk is rolled onto the bank. Because the bank's payments are eroded by inflation, it will demand and receive a premium on the loan it gives you — that is, a higher interest rate.
5-Year Government Bond Yields: Nominal vs. Real
The gap between the curves represents inflation expectations
When this article was first written, there was a 1% gap between a variable CPI-linked track and a variable unlinked track. So if, for example, the average rate on a "variable CPI-linked every five years" track was 2.35%, the average rate on a "variable unlinked" loan was 3.35%. That 1% gap reflected the market's inflation expectations for the next five years from 5/19 (that is, for 2024).
In 2024, as a result of events that took place in the country and also the war in Ukraine, inflation grew significantly and the inflation gap became 2.77%. We can see that the surge in the yields of nominal bonds was larger (by 50%) than that of real bonds. Why did this happen? Because of inflation.
In summary: why did the "unlinked" loan actually get affected by inflation?
When you took out a mortgage with a variable unlinked loan, your anchor was the nominal bond yield. That yield has two components: the real interest rate and inflation expectations. When inflation rose, inflation expectations rose with it, and the nominal yield surged. The result: your interest rate went up, even though the loan was "not linked to the CPI." The linkage isn't direct, but it's there — through the anchor.
One important point to stress: the takeaway is not that you should avoid a variable unlinked loan. There are no bad loans — only loans that don't suit a particular situation. The key is to understand the mechanism, know the risks, and combine the loans intelligently within your mortgage mixture. Once you understand that even an "unlinked" loan is exposed to inflation, you can make a more informed decision.
Good luck!