Inflation-Linked Bond [TIPS]

Inflation-linked bonds, also called inflation-indexed bonds, have principal and interest payments that adjust with inflation, protecting investors from purchasing power erosion. U.S. Treasury Inflation-Protected Securities (TIPS) adjust principal based on Consumer Price Index (CPI) changes. For example, a $1,000 TIPS with 2% coupon would pay $20 annually if no inflation, but if CPI rises 3%, principal adjusts to $1,030 and coupon payment becomes $20.60. At maturity, investors receive the greater of adjusted principal or original principal (deflation protection). Real yields on TIPS represent inflation-adjusted returns – negative real yields indicate investors accepting guaranteed losses after inflation for safety. The TIPS market totals $1.7 trillion, with maturities from 5 to 30 years. Other countries issue similar securities (UK Index-Linked Gilts, French OATi). Breakeven inflation rates (nominal Treasury yield minus TIPS yield) indicate market inflation expectations. TIPS outperform nominal bonds during unexpected inflation but underperform if inflation is lower than expected. Corporate inflation-linked bonds exist but are rare. Tax treatment is complex as inflation adjustments are taxable annually despite being paid at maturity.