What it means
A conventional bond promises a fixed number of dollars, which is fine until inflation quietly reduces what those dollars buy. These securities solve that by indexing the principal, so if prices rise 3% in a year, the principal rises 3% and every future payment is calculated on the larger amount.
The coupon rate itself never changes, which is why the quoted rate looks low next to a conventional bond of the same maturity. That gap between the two, often called the breakeven inflation rate, is effectively the market's expectation of average inflation over the life of the bond.
For businesses and pension schemes, the appeal is matching. An organisation with costs that rise with inflation, such as a fund paying index linked pensions or a charity committed to real spending, can hold these securities so that its assets and obligations move together.
There is protection on the downside too. If the index falls, the principal is adjusted down and coupon payments shrink, but at maturity the holder receives the greater of the adjusted principal and the original principal, so deflation cannot take back the initial investment.
The awkward nuance is tax. In many jurisdictions the annual increase in principal is treated as taxable income in the year it accrues, even though the investor does not receive that money until maturity, which is why these securities are often held inside tax sheltered accounts.
In practice
Real-world examples.
Example
A charitable foundation committed to distributing a fixed amount of real spending power each year moves a third of its bond allocation into inflation protected securities. When inflation jumps, its distributions keep their purchasing power without the trustees having to sell equities into a falling market.
Example
An investment committee compares a ten year conventional bond yielding 4% with a ten year inflation protected bond yielding 1.6%. The 2.4 percentage point gap is the breakeven rate, so the committee concludes the protected bond wins only if average inflation exceeds 2.4% over the decade.
Example
A retiree building an income floor buys a ladder of inflation protected securities maturing in each of the next fifteen years. The nominal amounts are unknown in advance, but the real value of each maturity is locked in, which is precisely what a spending plan needs.
Think of it
“TIPS protect against inflation-US government bonds that keep pace with prices.
Formula
Calculation
Adjusted principal = original principal x cumulative inflation factor
Coupon payment = adjusted principal x fixed coupon rate
An investor buys $100,000 of an inflation protected security with a fixed coupon rate of 1%. In the first year inflation runs at 3%, so the principal is adjusted to $100,000 x 1.03 = $103,000 and the coupon payment for that year is $103,000 x 1% = $1,030.
In the second year inflation is 2%, so the principal becomes $103,000 x 1.02 = $105,060 and the coupon payment rises to $105,060 x 1% = $1,050.60. A conventional bond with the same 1% coupon would have paid exactly $1,000 in both years and repaid only $100,000, whereas this holder is on track to receive $105,060 of principal after two years of inflation.Case study
Seen in the real world.
The following is a fictional, illustrative story. Larchmont Care Trust, an invented operator of residential care homes, had an endowment of $60,000,000 intended to subsidise fees for residents who could no longer afford them. Its cost base, mainly staff wages and food, rose faster than general inflation, but the endowment was invested almost entirely in conventional bonds chosen for their steady nominal income.
Across a five year stretch of higher inflation, the endowment's income held flat in dollar terms while the cost of the subsidy programme rose by roughly a quarter. The trustees were forced to cut the number of subsidised places twice, despite the portfolio performing exactly as designed.
After a review, the fictional trustees shifted around 40% of the endowment into inflation protected securities with maturities spread over fifteen years. The nominal yield on the portfolio fell, which made for an uncomfortable board meeting, but the income now moved with the cost base and the trust stopped having to shrink the programme every time prices rose.
Watch out
Common mistakes.
- Dismissing these securities because the quoted coupon looks low, without recognising that the low rate is a real rate and the inflation adjustment sits on top of it.
- Forgetting that the annual principal uplift may be taxable before it is received, which can create a cash outflow with no matching cash inflow.
- Assuming they protect against every kind of cost increase, when the adjustment follows a general price index that may bear little relation to a specific organisation's cost base.
Questions
People also ask.
What happens if there is deflation?
The principal is adjusted downward and coupons fall with it, but the holder still receives at least the original principal at maturity.
Are they less volatile than conventional bonds?
Not necessarily, because their prices still move with real interest rates, though they remove the risk that inflation erodes the eventual repayment.
Who should hold them?
Investors and institutions with long dated obligations that rise with prices, such as pension schemes, endowments and individuals planning decades of future spending.
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