An inflation-indexed bond, like a traditional bond, pays out interest at preset intervals and returns the original investment once the bond matures. Unlike a conventional bond, however, an inflation-indexed bond links its cash flow to actual inflation levels so that the real rate of return matches the nominal interest rate of the bond. In this way, both investors and issuers forgo the risks of fluctuating inflation levels in the future. Many industrialized countries, such as the United Kingdom and France, offer inflation-indexed bonds to pay for their debt. Inflation poses a greater threat, through gradual erosion of the principal, for a long-term bond as opposed to a short-term investment, making inflation-indexed bonds an attractive option in inflationary times for long-term investment.
For example, a ten-year $100 US Dollar (USD) conventional bond with a nominal three percent return and a predicted three percent inflation pays a real rate of seven percent. If the actual inflation level reaches five percent, the investor will receive only two percent per year on his investment. Moreover, he loses money if the inflation rate doubles to eight percent. With an inflation-indexed bond, on the other hand, the real return rate adjusts to eight percent to assure the nominal return rate of three percent. Even with eight-percent inflation, the inflation-linked bond guarantees the three-percent rate of return.
The United States Treasury issues notes or bonds called Treasury Inflation Protected Securities (TIPS). With a TIPS bond, the principal itself is regularly adjusted to protect it from inflation-related erosion. For example, the principal of a U.S. TIPS bond of $10,000 USD with a nominal return of four percent and an annual inflation rate of three percent will be adjusted at the first semi-annual payment date to $10,150 USD, with the upward adjustment of half of the annual inflation percentage. The interest will then be four percent of the inflation-adjusted principal, $406 USD. Furthermore, the principal never falls below the face value, even if the inflation-adjusted principal theoretically dips below the original investment.
Inflation-indexed bonds provide benefits to sovereign countries, as well. With traditional bonds, issuers pay higher amounts of interest than they expect to pay when inflation levels drop below the predicted level. For example, a three-percent nominal bond with predicted four-percent inflation pays a fixed real rate of seven percent. If inflation runs at an actual level of two percent, the issuer pays two percent more than he would otherwise have to pay to maintain the nominal return. When governments offer inflation-indexed bonds, the real rate always equals the nominal rate.
Investors generally accept lower stated rates for inflation-indexed bonds than for conventional bonds in exchange for elimination of the inflation risk. Interest rates in the economy consequently remain low. Low interest rates stimulate investment, research, development, and consumer spending. They also reduce the cost of servicing the federal debt.