Inflation-Linked Bonds
Bonds whose principal adjusts with a price index. They pay a real yield, and the difference against a nominal bond is the market's inflation expectation.
MadStockAlerts Research · Updated August 29, 2026
What to take away
- The principal adjusts with inflation, so the coupon payment rises with it too.
- The quoted yield is a real yield, before inflation rather than after.
- The breakeven rate is the difference against a nominal bond of the same maturity.
- They can lose value when real rates rise, even with inflation running high.
- The inflation adjustment is taxable in the year it accrues, before it is received.
MAD Academy Training Video · 0:45
The Principal Moves With Prices
Inflation-linked bonds adjust their principal with the price index, which protects purchasing power and creates a tax quirk.
This lesson is part of a Stock Alerts + Tools plan.
How the adjustment works
The principal of an inflation-linked bond is adjusted periodically in line with a published price index. The coupon rate is fixed and is applied to the adjusted principal, so the payment rises with inflation as well, and the adjusted principal is repaid at maturity.
| Nominal bond | Inflation-linked bond | |
|---|---|---|
| Coupon rate | Fixed | Fixed, applied to an adjusting principal |
| Principal at maturity | Fixed | Adjusted for cumulative inflation |
| Quoted yield | A nominal yield | A real yield |
| Inflation risk | Borne by the holder | Borne by the issuer |
US Treasury inflation-protected securities also carry a floor: the principal repaid at maturity is not less than the original face value, even after a period of deflation.
The breakeven rate
breakeven inflation = nominal yield - real yield, at the same maturity
- it is the inflation rate at which holding either bond produces the same return
- it is widely used as a market-implied inflation expectation
If a ten-year nominal Treasury yields 4.3 percent and a ten-year inflation-linked yields 1.8 percent, the breakeven is 2.5 percent. Inflation above that favours the linked bond; below it, the nominal.
The breakeven is an expectation plus a risk premium plus a liquidity difference, so reading it as a pure forecast overstates it. It is nonetheless one of the most watched market-based inflation measures available.
Why they can fall while inflation rises
The most common surprise for holders is a period in which inflation runs high and the bonds lose value. The explanation is that the price responds to real yields, and real yields can rise faster than the inflation adjustment compensates.
That is what occurred when central banks tightened aggressively against high inflation: real yields rose sharply from negative levels, and the duration effect on the price exceeded the accrued inflation adjustment.
The protection these bonds provide is against inflation relative to what was already expected, over the holding period to maturity. They are not protection against a mark-to-market loss in a rising real rate environment.
Scroll the chart sideways to see all of it.
- Inflation
- Real yield
- Bond price change, cumulative
The tax treatment
In the United States, the annual inflation adjustment to principal is treated as taxable income in the year it accrues, even though the holder does not receive it until maturity.
This produces a tax liability with no corresponding cash, sometimes described as phantom income. It is the mechanical reason these securities are often described as better suited to tax-advantaged accounts, and it is a description of the rule rather than tax advice.
Funds holding these securities pass the adjustment through as a distribution, which changes the cash-flow position without changing the underlying treatment.
The index lag
The inflation adjustment references a price index from roughly three months earlier, which introduces a lag between inflation occurring and the adjustment appearing in the bond.
In periods of stable inflation the lag is immaterial. When inflation changes rapidly it matters: the bond is adjusting for conditions from a quarter ago while the market is pricing conditions now, and the two can differ substantially.
The lag also produces a small seasonal pattern in the accrued adjustment, since the referenced index has its own seasonality. It is a technical detail rather than a defect, and it is one reason short-dated inflation-linked bonds behave differently from long-dated ones.
For a holder to maturity the lag washes out, since the cumulative adjustment over the life of the bond reflects cumulative inflation. It affects the mark-to-market value along the way rather than the eventual outcome.