Inflation-linked bond

What is an inflation-linked bond

An inflation-linked bond is a bond whose principal, and therefore its interest payments, rise and fall with an official inflation index.

A normal bond pays a fixed coupon on a fixed face value. Inflation eats into the value of those payments. An inflation-linked bond protects against that by adjusting the principal to the price level.

Worked example (hypothetical)

Take an imaginary government bond with these terms:

• The face value is set at issue.
• The coupon rate is fixed and stated as a "real" rate.
• The principal is linked to the national consumer price index (CPI).

Suppose the CPI rises over the year. The issuer multiplies the original principal by the ratio of the new index level to the index level at issue. The adjusted principal is now higher by the same percentage as the CPI increase.

The fixed coupon rate is then applied to this higher principal, so each coupon payment is larger in money terms. At maturity the holder receives the adjusted principal, not the original one.

If the CPI falls, the principal is adjusted down and coupons shrink. To try your own numbers, use the tools on the calculators page or a spreadsheet: adjusted principal = original principal × (current index ÷ base index).

Formal definition and mechanics

For experienced readers, the key points are these:

• Real yield. The market yield on an inflation-linked bond is a real yield, meaning return above inflation. A nominal bond's yield includes expected inflation.
• Breakeven inflation. The nominal yield minus the real yield on a bond of similar maturity is the breakeven inflation rate. Markets read it as an estimate of expected inflation plus risk premiums. It is not a forecast.
• Index lag. The index used for adjustment usually lags the calendar date, so the bond does not track inflation in real time.
• Deflation floor. Some issues guarantee that the principal repaid at maturity will not fall below the original face value. Others have no floor. Check the bond's terms.
• Accrued inflation. Trades between coupon dates settle with accrued interest on the adjusted principal, and quoted prices are often "clean" real prices multiplied by an index ratio.
• Price risk remains. The principal is protected against inflation, but the market price still moves with real yields. If real yields rise, the price can fall. Duration applies to real yields.
• Credit risk remains. Inflation linking does not remove the risk of default by the issuer.

TIPS and other names

TIPS bonds are Treasury Inflation-Protected Securities, the US government's inflation-linked bonds, indexed to a US consumer price index. The UK calls its version index-linked gilts. Other governments issue similar bonds under local names, often sold through a bond auction.

Where you see the term

• News and central bank reports: breakeven inflation and real yields are quoted when markets discuss inflation expectations and policy rates.
• Market data screens: real yields on TIPS appear next to nominal Treasury yields.
• Macro analysis: traders follow real yields when reading fundamental analysis of the US dollar, gold and stock indices.

These bonds are usually not traded directly on retail CFD platforms. Real-yield moves can still affect the price of instruments that are traded on them. Leveraged CFD trading can lose money fast.

Related terms

• Coupon (bond)
• Face value (par value)
• Deflation and Disinflation
• Bond duration
• Basis point
• Credit spread
• Trading glossary

Frequent questions

What does inflation-linked bond mean in simple words?

It is a bond whose principal and payments grow with inflation, so its value keeps pace with prices as measured by an index.

Are TIPS bonds risk-free?

No. They protect against US inflation, but their market price falls when real yields rise. Holders outside the US also carry currency risk.

What happens in deflation?

The principal is adjusted down. Some bonds, including TIPS, repay at least the original face value at maturity. Check each bond's terms.

What is breakeven inflation?

It is the difference between a nominal bond yield and an inflation-linked bond yield of similar maturity. Markets read it as implied inflation expectations.