Index‑Linked Bond: Definition, How They Work, and Example

What is an index‑linked bond?

An index‑linked bond (also called a real return bond, TIPS in the U.S., or a linker in the U.K.) is a fixed‑interest government bond whose coupon payments and/or principal are adjusted according to a price index—typically the Consumer Price Index (CPI). The adjustment preserves the bondholder’s purchasing power by delivering a known real rate of return rather than a purely nominal return.

Key takeaways

• Payments (interest and/or principal) are adjusted for changes in an inflation index, commonly the CPI.
• Issuers—usually governments—offer a stated real yield plus accrued inflation.
• These bonds reduce inflation risk and tend to be less volatile than nominal (non‑indexed) bonds.

How index‑linked bonds work

• At issuance, the bond carries a real coupon rate (the real yield) and a reference index value (e.g., CPI at issue).
• As the reference index changes, an indexation factor = (current index ÷ index at issue) is applied to the principal and typically to coupon payments.
• Coupon payments are calculated on the inflation‑adjusted principal. At maturity, the inflation‑adjusted principal is repaid.
• The result is that the investor receives the agreed real yield plus compensation for inflation that occurred while holding the bond.

This structure converts nominal returns into real returns: the CPI serves as the “exchange rate” that translates nominal cash flows into inflation‑adjusted (real) cash flows.

Example

Two bonds, same terms, issued at $100 with a 4% coupon and one year to maturity:
* Issue CPI = 204. Coupon = $4 on $100 principal.
* One year later CPI = 207. Indexation factor = 207 / 204 ≈ 1.0147 (inflation ≈ 1.47%).
* Inflation‑adjusted redemption = ($100 principal + $4 coupon) × 1.0147 = $104 × 1.0147 ≈ $105.53.
* Nominal return ≈ (105.53 − 100) / 100 = 5.53%.
* Approximate real return ≈ nominal return − inflation = 5.53% − 1.47% = 4.06% (≈ the stated real coupon).

This illustrates how the bond preserves a real yield (about 4%) while adding compensation for realized inflation.

Benefits

• Inflation protection: preserves purchasing power by indexing payments to inflation.
• Predictable real return: investors know the real yield at purchase.
• Lower volatility relative to nominal bonds when inflation expectations change.

Considerations and risks

• Real yields can be low or negative in some market environments.
• Indexation is tied to a specific measure of inflation (e.g., CPI); measurement methodology risk exists.
• Tax treatment may make inflation adjustments taxable in some jurisdictions even before cash is received.
• If deflation occurs, some index‑linked bonds have floor provisions (e.g., principal won’t fall below par), but features vary by issue.

Who might use them

• Investors seeking to protect purchasing power from inflation.
• Conservative investors or retirees looking for predictable real income.
• Portfolio managers using them as an inflation hedge or for diversification.

Conclusion

Index‑linked bonds provide a straightforward way to secure a known real return while remaining protected from inflation. They are especially useful for investors who prioritize preserving purchasing power and reducing inflation‑related uncertainty in fixed‑income holdings.