Inflation-Linked Bond
Also known as: TIPS, Linkers, ILB
A bond that grows with the price level — real purchasing power, contractually guaranteed.
- Asset class
- Fixed income (real rates)
- Instrument type
- Index-linked sovereign bond
- Traded
- OTC dealer market
- Typical users
- Pensions, endowments, inflation hedgers
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.
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).
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:
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.
Linker books are hedged on the two axes separately: real-rate risk with linkers/futures, breakeven risk with inflation swaps or nominal-linker pairs.