Inflation-Linked Bond
Also known as: TIPS, Linkers, ILB
A bond that grows with the price level — real purchasing power, contractually guaranteed.
1 · SnapshotThe one idea to remember
2 · BeginnerWhat is it, really?
An ordinary bond promises fixed currency amounts; inflation decides what they're worth. An inflation-linked bond promises fixed purchasing power: its principal is scaled up with a consumer price index, and coupons are paid on that growing principal.
Own a linker through years of 5% inflation and both your principal and coupons ratchet up ~5% per year; a conventional bondholder just quietly loses. The linker's quoted "real yield" is the return you earn above inflation, whatever inflation turns out to be.
The most famous versions are US TIPS, UK index-linked gilts, and euro-area linkers (Bunds/OATs indexed to euro HICP). Most guarantee at least original principal back at maturity even after deflation.
a paymentonly if a condition is metnot a payment
The published index does not change the coupon rate. It changes the amount that rate is applied to.
At issue
- The investor → The government The real coupon is fixed and is small, because it is a return on top of inflation rather than including it.
Continuously
- The price index → The government The face amount is restated by the change in the index, with a lag of a few months built into the terms.
Every coupon date
- The government → The investor A small rate on a growing amount. The cash coupon therefore rises with inflation without the rate ever changing.
At maturity
- The government → The investor Most sovereign linkers guarantee at least the original face amount even after deflation. That floor is a term of the issue and not a property of linkers.
- Asset class
- Fixed income (real rates)
- Instrument type
- Index-linked sovereign bond
- Traded
- OTC dealer market
- Typical users
- Pensions, endowments, inflation hedgers
Which risks decide the outcome
Not how risky this is, and not a rating — there is deliberately no total. It says which of five failure modes drives what happens here, in the same order on all 129 products so they can be compared. This publication's own reading; see the notice below.
- Marketdecides it
- Creditmatters
- Liquiditymatters
- Fundingbarely applies
- Operationalbarely applies
What decides it here. The real rate decides the price. Inflation changes the amount the coupon is applied to rather than the coupon itself, which is why these fall in a rate rise even when inflation is high.
3 · IntermediateHow it works in practice
Mechanics
- Index ratio: principal × (CPI now / CPI at issue), applied with a ~2–3 month lag.
- Cash flows: real coupon × indexed principal each period; indexed principal (floored at par for most issuers) at maturity.
- Quotes: in real yield and real (unindexed) price; settlement multiplies by the index ratio.
Breakeven inflation — the market's forecast
Compare a 10-year nominal yield (say 4.0%) with the 10-year real yield on a linker (say 1.6%): the difference, 2.4% breakeven, is the average inflation at which both bonds return the same. Buy linkers if you expect inflation above breakeven; nominals if below. Breakevens are among the most-watched inflation expectation gauges anywhere.
What linkers hedge — and what they don't
They hedge realised CPI inflation over the holding period to maturity. They do not shield you from real-rate risk: if real yields rise, linker prices fall like any bond's (2022: US real yields jumped ~250bp and long TIPS lost heavily even as inflation ran hot).
4 · AdvancedPricing & valuation
Pricing: real cash flows on a real curve
Value indexed flows by discounting real amounts at real zero rates \(\rho_t\), or equivalently nominal expected flows at nominal rates — Fisher links the curves:
What the symbols mean
- ythe yield to maturity
- nhow many periods, or how many things
- rthe interest rate, per year
- pia probability, or a profit, depending on the line above
where \(\pi^e\) is expected inflation and IRP the inflation risk premium. Breakeven = \(\pi^e\) + IRP − liquidity premium on the linker: unpacking those three is a research industry.
Convexity and the lag
The indexation lag makes the last months of a linker effectively nominal, and seasonality in CPI (unadjusted indices) creates predictable price patterns that carry traders arbitrage. The deflation floor is an embedded put on the price index, valued with inflation option models (year-on-year vs. zero-coupon inflation caps/floors).
Inflation derivatives connection
Zero-coupon inflation swaps quote fixed \(K\) against realised index growth: pays \(\big[\tfrac{I_T}{I_0} - (1+K)^T\big]\). Swap breakevens vs. bond breakevens define the linker asset-swap basis — a barometer of balance-sheet and liquidity conditions in the linker market.
What the symbols mean
- Deltahow much a derivative moves when the underlying moves
- Pa price, or a present value
- Dduration: how far a bond's cash flows sit in the future
- rthe interest rate, per year
- ythe yield to maturity
- pia probability, or a profit, depending on the line above
Linker books are hedged on the two axes separately: real-rate risk with linkers/futures, breakeven risk with inflation swaps or nominal-linker pairs.
The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.
5 · Desk notesHow practitioners think about it
Now say it back
Close the page and give Inflation-Linked Bond in four sentences. It takes a minute and it is the only way to find out whether reading it was enough.
- Who wants what — two parties wanted opposite things badly enough to write it down.
- What the contract obliges, and when — not the payoff; the obligation.
- Where the money comes from — name the source, or you have described a hope.
- What makes it lose — the ordinary way, not the dramatic one.
Put Inflation-Linked Bond beside any other instrument →
Where this instrument shows up elsewhere
- EasyInflationConceptsThe only loss that requires no market move, arrives every year, and never appears on a statement
- EasyWhat is a bond, in plain words?QuestionsA loan cut into tradeable pieces
- EasyWhy is my money worth less even though it grew?QuestionsTwo numbers are moving
- MediumPensions & RetirementIndustryOwing somebody a payment in thirty years and investing towards it — where the discount rate is as consequential as…
- MediumThe Yield CurveConceptsOne line, drawn from overnight to 30 years — the bond market's forecast, the economy's mood ring, and a P&L engine…
- MediumWhich Desk Trades WhatPrepEleven trading seats and six that sit next to them: what each one actually touches, the single number it lives by,…
- HardInsurance InvestmentIndustryInvesting premiums against liabilities that were written before the assets were bought — where the benchmark is a…