Definition and Mechanics
An inflation-linked bond (also called an inflation-indexed bond) is a debt instrument whose principal is adjusted in line with a consumer price index (CPI). As inflation rises, the principal increases and coupon payments - calculated on the adjusted principal - rise accordingly, preserving the investor's real purchasing power. Prominent examples include U.S. TIPS (Treasury Inflation-Protected Securities), UK index-linked gilts, and Japan's inflation-linked JGBs.
Here is a numerical example. You purchase an inflation-linked JGB with a face value of 1 million yen and a coupon rate of 0.5%. If CPI rises 3% over the first year, the principal adjusts to 1.03 million yen. The coupon is then 1,030,000 × 0.5% = 5,150 yen, up from the initial 5,000 yen. At maturity, the inflation-adjusted principal is returned.
Real Yield and Breakeven Inflation Rate
Inflation-linked bond yields are expressed as 'real yields.' The difference between a nominal government bond yield and the real yield of an inflation-linked bond of the same maturity is the 'breakeven inflation rate' (BEI), which represents the market's inflation expectation. For example, if the 10-year nominal JGB yields 1.0% and the 10-year inflation-linked JGB yields -0.5%, the BEI is 1.5%, meaning the market expects average annual inflation of 1.5% over the next decade.
If actual inflation exceeds the BEI, the inflation-linked bond outperforms; if it falls short, the nominal bond wins. During the global inflation surge of 2022-2023, U.S. TIPS significantly outperformed conventional Treasuries. In Japan, CPI increases since 2022 have also drawn attention to inflation-linked JGBs.
Common Misconceptions and Investment Considerations
The biggest misconception is that inflation-linked bonds always profit during inflation. Their prices are also affected by changes in real interest rates. If real rates rise, inflation-linked bond prices fall, so losses can occur even amid high inflation. In 2022, despite U.S. inflation exceeding 8%, the Fed's aggressive rate hikes caused TIPS prices to decline temporarily. Books on asset protection during inflationary periods are available on Amazon
Japan's inflation-linked JGBs feature a unique 'floor' (principal guarantee): even if deflation occurs, the redemption amount at maturity will not fall below face value - a feature absent from U.S. TIPS. For retail investors, inflation-linked bond funds or ETFs are the practical route. Allocating 10-20% of a portfolio to inflation-linked bonds can meaningfully improve resilience against inflation risk.