Lesson 4 of 7 · 11 min
Index-linked and inflation-linked bonds
Inflation-linked bonds protect real value by adjusting cash flows to a price index: capital-indexed bonds scale the principal (and so the coupon), while interest-indexed bonds adjust only the coupon.
In short
- Index-linked bonds tie interest and/or principal to an index; by far the most common are inflation-linked bonds (linkers) tied to a consumer price index.
- Real interest rate ≈ nominal rate − inflation. Fixed nominal cash flows lose purchasing power as prices rise.
- Capital-indexed: the principal is adjusted by the index; the fixed coupon rate is applied to the adjusted principal (e.g., TIPS).
- Under deflation the adjusted principal falls, but investors usually get the greater of adjusted principal or par at maturity.
- Interest-indexed: principal stays at nominal par; only the coupon is indexed. It works like an FRN whose MRR is inflation.
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