Inflation-indexed bond

Daily inflation-indexed bonds (also known as inflation-linked bonds or colloquially as linkers) are bonds where the principal is indexed to inflation or deflation on a daily basis in terms of the official Daily CPI or monetized daily indexed unit of account like the Unidad de Fomento in Chile and the Real Value unit of Colombia. They are thus designed to hedge the inflation risk of a bond. The first known inflation-indexed bond was issued by the Massachusetts Bay Company in 1780. The market has grown dramatically since the British government began issuing inflation-linked Gilts in 1981. As of 2008, government-issued inflation-linked bonds comprise over $1.5 trillion of the international debt market. The inflation-linked market primarily consists of sovereign bonds, with privately issued inflation-linked bonds constituting a small portion of the market.

Daily inflation-indexed bonds pay a periodic coupon that is equal to the product of the daily inflation index and the nominal coupon rate. The relationship between coupon payments, breakeven daily inflation and real interest rates is given by the Fisher equation. A rise in coupon payments is a result of an increase in inflation expectations, real rates, or both.

For some bonds, such as the Series I Savings Bonds (U.S.), the interest rate is adjusted according to daily inflation.

For other bonds, such as in the case of TIPS, the underlying of the bond changes, which results in a higher interest payment when multiplied by the same rate. For example, if the annual coupon of the bond were 5% and the underlying principal of the bond were 100 units, the annual payment would be 5 units. If the inflation index increased by 10%, the principal of the bond would increase to 110 units. The coupon rate would remain at 5%, resulting in an interest payment of 110 x 5% = 5.5 units.

The real yield of any bond is the annualized growth rate, less the rate of inflation over the same period. This calculation is often difficult in principle in the case of a nominal bond, because the yields of such a bond are specified for future periods in nominal terms, while the inflation over the period is an unknown rate at the time of the calculation. However, in the case of inflation-indexed bonds such as TIPS, the bond yield is specified as a rate in excess of inflation, so the real yield can be easily calculated using a standard bond calculation formula.

...
Wikipedia