Quick Orientation
Inflation-linked bonds (ILBs) are designed to protect investors against inflation by linking either the principal or coupon payments to an official inflation index. Their main purpose is to preserve the investor’s real purchasing power.
Key Features
| Feature | Description |
|---|---|
| Inflation Protection | Principal and/or coupon payments rise with inflation. |
| Real Return | Investors earn a real yield (over inflation), not a nominal one. |
| Indexation | Usually linked to CPI, RPI (UK), or other national inflation measures. |
| Lower Nominal Coupon | Base coupons are usually lower than regular bonds because inflation is added later. |
| Tax Treatment | Inflation adjustments may be taxable (varies by jurisdiction). |
| Long Duration | Often issued with long maturities (10–30 years) to hedge long-term inflation risk. |
1. Principal-Indexed Bonds (Most Common)
The face value of the bond increases with inflation. The coupon rate is fixed but is applied to the inflation-adjusted principal.
Example: Original principal: $1,000; Annual coupon: 2%; Inflation: 5%.
Adjusted principal = $1,000 × 1.05 = $1,050.
Annual coupon = 2% × $1,050 = $21.
2. Coupon-Indexed Bonds (Less Common)
The coupon payment is directly linked to inflation, but the principal is fixed.
Example: Principal: $1,000; Coupon: CPI inflation + 1%; Inflation: 4%.
Annual coupon = 4% + 1% = 5% → $50 payment. The principal remains $1,000.
🇺🇸 TIPS (Treasury Inflation-Protected Securities) – USA
U.S. government bonds whose principal value adjusts with the U.S. CPI-U. Maturities are 5, 10, and 30 years. If deflation occurs, the principal will not fall below the original par value.
🇬🇧 Index-Linked Gilts – United Kingdom
UK government bonds where both principal and coupons are linked to the Retail Price Index (RPI), with a lag of about 3 months.
🇫🇷 OATi & OAT€i – France
French Treasury issues two types: OATi (linked to French CPI) and OAT€i (linked to Eurozone HICP).
🇮🇹 BTP Italia – Italy
Italian government bonds indexed to the Italian CPI, often sold directly to retail investors.
🇯🇵 JGBi – Japan
Japanese inflation-linked government bonds that link principal to Japan’s CPI. They include a "deflation floor" ensuring investors receive at least 100% of the original principal.
| Feature | Nominal Bond | Inflation-Linked Bond |
|---|---|---|
| Coupon | Fixed | Fixed rate × inflation-adjusted principal |
| Principal | Fixed | Adjusts with inflation |
| Risk | Inflation risk to investor | Inflation risk transferred to issuer |
| Yield | Nominal yield | Real yield |
| Use Case | Income generation | Purchasing power protection |
- Pension Funds: To match inflation-linked liabilities (e.g., retiree benefits).
- Insurance Companies: To hedge long-term inflation exposure.
- Retail Investors: To preserve the real value of savings.
- Central Banks / Sovereign Wealth Funds: For diversification and real-return allocation.
Breakeven Inflation Rate (BEI) = Nominal Yield – Real Yield
The BEI is the market’s expectation of average inflation over the bond’s life. If you expect actual inflation to be higher than the BEI, the inflation-linked bond is attractive. If you expect it to be lower, the nominal bond is better.
Example: 10Y Treasury nominal yield = 4.5%; 10Y TIPS real yield = 2.0%.
BEI ≈ 4.5% - 2.0% = 2.5%. If you think inflation will average >2.5%, buy TIPS.
- Deflation Risk: If inflation turns negative, principal and coupons may shrink (though floors often exist).
- Index Lag Risk: There’s usually a 2-3 month lag in inflation adjustment.
- Liquidity Risk: Some ILB markets are less liquid than their nominal counterparts.
- Tax Risk: Inflation adjustments may be taxed as income annually, even though the cash is not received until maturity ("phantom income").
- Real vs. Nominal Yield Mispricing: If breakeven inflation expectations change, ILBs can underperform.
Q: How does a TIPS bond protect against inflation?
A: Its principal is indexed to the CPI. Coupons are paid on the adjusted principal, and you receive the final inflation-adjusted amount at maturity, preserving purchasing power.
Q: What is “breakeven inflation”?
A: It’s the difference between the yield on a nominal bond and an inflation-linked bond of the same maturity. It represents the market's average inflation expectation over that period.
Q: What happens if there’s deflation?
A: The principal and coupons may shrink. However, many ILBs like TIPS have a "deflation floor," meaning the principal paid at maturity will not be less than the original par value.