An inflation-linked bond is a bond that provides protection against inflation. Most inflation-linked bonds, the Canadian "Real Return Bond "(RRB), the British "Inflation-linked Gilt" (ILG) and the new U.S. Treasury "inflation-protected security" (IPS) are principal indexed. This means their principal is increased by the change in inflation over a period. In most countries, the Consumer Price Index (CPI) or its equivalent is used as an inflation proxy. As the principal amount increases with inflation, the interest rate is applied to this increased amount. This causes the interest payment to increase over time. At maturity, the principal is repaid at the inflated amount. In this fashion, an investor has complete inflation protection, as long as the investor's inflation rate equals the CPI.
We must compare an inflation-linked bond to a conventional or "nominal" bond to understand it properly. A normal bond pays its coupon on a fixed principal amount. Using the Government of Canada 8% bond maturing in 2023 as an example, we are due 8%, or $8 on every $100 of principal, each year until we are finally repaid our principal of $100 at maturity. Contrast this with the Canadian RRB, the 4.25% maturing in 2021. It pays a 4.25% "real" interest rate or $4.25 on its principal each year. But the principal increases with inflation, which is based on the Canadian CPI. For example, when Canadian inflation, the CPI, was 1.8% in 1995, the principal amount was increased by 1.8%. Since its issue in November 1991, the RRB has seen its principal amount increase by 8% to $108. The 4.25% coupon now generates a payment of $4.60 versus its original payment of $4.25. At maturity, when the principal will be repaid by the Canadian government, the principal amount will have increased to well over $200.
By applying a "real" interest rate or coupon to the principal amount, an inflation-linked bond protects the investor from unexpected changes in the consumer price index. Normally, bond investors demand an extra "yield premium" or compensation for inflation risk. Since inflation-linked bonds are not exposed to inflation, their yield is lower than normal or nominal bonds. As of December 1996, a thirty year Canada bond has a yield of about 7%. The Canadian RRB has a yield of 4.2%. The 2.8% difference between these two bonds reflects the "break-even inflation rate". This means that inflation would have to average more than 2.8% per year until the maturity of the bond for the inflation-linked bond to do better than another bond of similar term. Investors do not necessarily expect inflation to be as high as 2.8%, since they do not know what the future will bring they are willing to sacrifice some current yield for inflation protection on the principal.
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