Inflation-Linked Bonds and TIPS

A normal bond promises a fixed number of dollars back. If inflation runs hot over the life of that bond, those dollars buy less than the investor expected when they bought it — the coupon is fixed, but purchasing power isn't. Inflation-linked bonds fix that by making the thing that's fixed the real value, not the dollar value.

How the adjustment works

Each bond has a fixed real coupon rate, set at issuance. The principal is not fixed — it's scaled every period by the ratio of the current inflation index to the index level at issuance:

$$\text{Adjusted principal} = \text{Face value} \times \frac{\text{CPI}_{\text{today}}}{\text{CPI}_{\text{issuance}}}$$

In words: take the original $1,000 (or whatever) face value and scale it up by however much prices have risen since the bond was issued. Every coupon payment is then the fixed real rate applied to this larger, adjusted principal — so both the coupon and the amount you get back at maturity grow with realized inflation.

Worked example

A TIPS is issued with $1,000 face value and a 1.50% real coupon, paid semiannually. At issuance, the reference CPI index is 300. Two years later, CPI has risen to 315. The adjusted principal is:

$$1{,}000 \times \frac{315}{300} = 1{,}050$$

The semiannual coupon paid at that point is $1.50\% / 2 \times 1{,}050 = 7.88$, versus the $1.50\%/2 \times 1{,}000 = 7.50$ it would have paid on the original, unadjusted face. If the bond is held to maturity and CPI has risen further to an index of 330 by then, the redemption amount is $1{,}000 \times 330/300 = 1{,}100$ — $100 more than face value, purely reflecting realized inflation over the bond's life.

What this means in practice

TIPS are the standard tool for investors who specifically want protection against inflation eroding their bond's real value — pension funds and insurers with inflation-linked liabilities are natural buyers. But they underperform nominal Treasuries if inflation comes in lower than what was priced into TIPS yields at purchase, which is exactly what the breakeven inflation rate is designed to measure.