Ordinary bonds have a problem: inflation erodes the real value of every coupon payment and the principal you get back. If you lend £1,000 at 3% for 10 years, and inflation runs at 4% the whole time, you've actually lost purchasing power despite receiving interest. Inflation-linked bonds solve this by adjusting your payments to inflation — automatically.
The principal of an inflation-linked bond is adjusted upward with inflation. The coupon is a fixed percentage of this adjusted principal — so as the principal grows with inflation, the coupon payment grows too. At maturity, you receive the inflation-adjusted principal, not the original face value.
After 10 years of 5% inflation, the principal grows to ~£1,629. At maturity, you receive £1,629 — your purchasing power is protected.
TIPS are the US equivalent, issued directly by the Treasury. They adjust principal to CPI (Consumer Price Index) twice yearly. The coupon is fixed; the payment grows as principal grows. At maturity, you receive the higher of the inflation-adjusted principal or the original face value — so deflation can't hurt you below par.
TIPS are quoted with a real yield — the return above inflation. In normal times, TIPS real yields are slightly below nominal Treasury yields, because investors pay a "safety premium" for inflation protection. When real yields are negative (as they were in 2020–2021), you're effectively paying for the insurance.
UK index-linked gilts are adjusted to the UK Retail Price Index (RPI), which tends to run slightly above CPI — a small advantage for holders. They've been issued since 1981, originally created partly to attract pension funds that needed to match inflation-linked liabilities. UK pension funds hold enormous quantities of index-linked gilts as liability-matching instruments.
They're most valuable when you expect inflation to run above what's already priced into markets (the "breakeven inflation rate" — the difference between nominal and TIPS yields). In 2021–2022, investors who held TIPS were significantly better off than those in nominal Treasuries as inflation surged to 40-year highs. When inflation is low or falling, nominal bonds typically outperform.
Breakeven inflation rate: if a 10-year Treasury yields 4.5% and the equivalent TIPS yields 2%, the breakeven is 2.5%. This means the market expects 2.5% average inflation over the next decade. If you think inflation will be higher, buy TIPS. If you think lower, buy nominal Treasuries. You're essentially making a bet on future inflation relative to market expectations.
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