What it means
On a conventional bond the amount repaid is fixed in cash terms, so high inflation quietly erodes what the money is worth by the time it comes back. An index-linked bond removes that problem by uprating the principal in line with a consumer price index.
The coupon rate is set in real terms and is usually low, often well under 2%, because it sits on top of whatever inflation adds. Each interest payment is calculated as that real rate applied to the inflation-adjusted principal, so the cash coupon grows as prices rise.
For investors with long-dated real liabilities, such as pension schemes paying inflation-linked benefits, these bonds match assets to obligations more closely than anything else available. That structural demand is why real yields on them can sit near or below zero.
The headline number to watch is the break-even inflation rate, meaning the gap between the yield on a conventional bond and the real yield on an index-linked bond of the same maturity. If actual inflation exceeds that gap, the index-linked bond was the better buy.
The nuance is that these bonds are not risk free. Their prices still move with real interest rates, long-dated issues can be very volatile, and in some tax systems the inflation uplift is taxable in the year it accrues even though no cash is received until maturity.
Liquidity and issuance also shape the market. Index-linked issues are a small slice of most government bond markets, so trading them in size can move prices more than an equivalent conventional bond would.
In practice
Real-world examples.
Example
A pension scheme with benefits that rise annually with prices buys $80 million of long-dated index-linked government bonds, so that its assets and its promises move together rather than drifting apart.
Example
A private investor worried about a decade of higher inflation switches part of a conventional bond holding into index-linked issues, accepting a lower starting yield in exchange for inflation protection. If inflation instead falls back below the break-even rate, the switch will have cost her return, and she accepts that as the price of insurance.
Example
A toll road operator with revenues contractually tied to the consumer price index issues an inflation-linked corporate bond, matching the cost of its debt to the behaviour of its income.
Formula
Calculation
Inflation-adjusted principal = Original principal x (Index level at payment date / Index level at issue), and Coupon paid = Real coupon rate x Inflation-adjusted principal.
Suppose an investor buys $100,000 of an index-linked bond with a real coupon of 1.5%, issued when the price index stood at 100. After one year the index has risen to 103, meaning 3% inflation. Adjusted principal = $100,000 x (103 / 100) = $103,000. Coupon paid = 1.5% x $103,000 = $1,545, against $1,500 on an unindexed equivalent.
By maturity ten years later the index has reached 134. Principal repaid = $100,000 x (134 / 100) = $134,000, so the investor receives $34,000 more than the original face value, alongside coupons that have grown each year with the index.Case study
Seen in the real world.
Larkfield Municipal Pension Fund is a fictional scheme created for this illustrative case. It owed inflation-linked pensions to about 4,000 former staff and had funded them mostly with conventional fixed-rate bonds.
When inflation ran at 6% for two consecutive years, the fund's liabilities grew far faster than its bond portfolio, and the deficit widened by roughly $22 million. The trustees restructured, moving $150 million into index-linked bonds so that around two thirds of the inflation exposure was matched.
The fictional trustees accepted the trade-off openly. Real yields were low, so the expected return on the new holdings was modest, but the fund was no longer exposed to the single risk that had done it the most damage.
Watch out
Common mistakes.
- Reading the low coupon as a poor return. The quoted rate is a real rate, and the inflation uplift is added on top through the adjusted principal.
- Assuming index-linked bonds cannot lose value. Their prices fall when real yields rise, and long-dated issues can drop sharply even while inflation is high.
- Ignoring the lag in the index used, because most structures reference an index reading from a couple of months earlier rather than the current month.
Questions
People also ask.
What is break-even inflation?
It is the difference between a conventional bond's yield and an index-linked bond's real yield, and it shows the inflation rate at which the two would perform equally.
Do index-linked bonds protect against deflation?
Partly, since many government issues guarantee repayment of at least the original face value even if the index falls over the bond's life.
Are the inflation adjustments taxed?
In several countries yes, and the uplift can be taxable as it accrues, which makes these bonds better suited to tax-sheltered accounts.
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