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An inflation-linked bond is generally a bond that is issued by a government. These bonds have built-in protection from losing their value due to inflation. With such bonds, the principal amount owed to the investor increases with any rise in inflation levels that occur in the locality of the issuer. As a result, the interest rate of an inflation-linked bond will return higher monthly payments to investors when it is attached to the increased principal amount. Inflation-linked bonds lose a bit of their value at times of deflation, which causes the principal to stagnate and causes the bond to lag behind other higher-yielding bonds in the market.
Bonds are essentially loans granted by investors to some sort of institution, like a government or a corporation, wishing to raise funds. In return for their loans, investors are granted regular interest payments as well as the eventual return of the principal amount that was initially loaned. If inflation rises considerably during the term of the bond, investors may not be getting quite the value they desire from their investments. As a result, governments may issue some sort of inflation-linked bond as a way for investors to receive some sort of protection from high inflation.
With an inflation-linked bond, an investor loans out a principal amount and is quoted an interest rate, also called a coupon rate, for regular interest payments. At any point during the life of the bond, the principal amount may go up if some economic indicator, usually a national price index, indicates rising inflation. As a result, interest payments will rise accordingly.
For example, imagine an investor buys an inflation-linked bond for $100 US Dollars (USD) with a 10 percent coupon rate, meaning that interest payments are usually $10 USD. At some point during the life of the bond, inflation in the United States rises by five percent. That means that the principal of the bond will also rise by five percent to $105 USD. The interest rate of 10 percent, applied to that new amount, yields interest payments that rise to $10.50 USD.
The most important factor in an inflation-linked bond being profitable is some degree of inflation during the life of the bond. Since inflation is anticipated with these bonds, the coupon rates are generally much lower than they are for bonds whose principal amounts stay static. As a result, a lack of inflation means that the inflation-linked bonds won't return at nearly the same rate as other bonds.