Bonds whose principal and coupon payments are automatically adjusted in line with inflation, protecting investors from the erosion of purchasing power that affects conventional fixed-rate bonds.
Unlike standard bonds, where inflation diminishes the real value of future coupon and principal payments, inflation-linked bonds (such as U.S. Treasury Inflation-Protected Securities (TIPS) or UK Index-Linked Gilts) increase their principal value according to changes in an inflation index—typically the Consumer Price Index (CPI). As a result, both the interest payments (calculated on the adjusted principal) and the final redemption amount rise with inflation, ensuring a real rate of return.
However, inflation-linked bonds are not immune to interest rate risk. When inflation expectations rise sharply, central banks may respond with rate hikes, leading to price declines across fixed-income markets—including inflation-linked securities. Their advantage lies in offering relative protection against inflation compared with nominal bonds, though total returns can still be negative if rising yields outweigh the inflation adjustment.
In essence, inflation-linked bonds aim to preserve an investor’s purchasing power, providing returns that reflect inflation plus a real yield, rather than a fixed nominal rate.
