An inflation-indexed bond is a debt security that adjusts the underlying principal balance based on an inflation index, such as the Consumer Price Index (in the USA) or the Retail Price Index (in the UK). If the inflation rate rises, then the principal balance will also rise, which in turn increases the amount of interest paid to investors. The bonds have a deflation floor built into them, so that the principal balance does not decline if the associated inflation index turns negative. For example, an investor buys a bond at its face value of $1,000. The bond is indexed to the Consumer Price Index, which revealed a 2% inflation rate during the first year. This results in an inflation-adjusted bond principal balance of $1,020 at the end of the year. The bond has a 3% interest rate, which would normally result in a $30 total annual payment to the investor. However, as of the principal adjustment date, the annual interest changes to $30.60 to account for the increased principal balance on the bond.
These bonds are designed to mitigate the risk of inflation within the country where the bonds have been issued. This is a major benefit for investors acquiring bonds in countries that suffer from high levels of inflation, and also mitigates the risk of unexpected changes in inflation in any country. Inflation-indexed bonds have been issued by a number of national governments, though issuances from the private sector are relatively insignificant.