The first known inflation-indexed bond was issued by theMassachusetts Bay Companyin 1780. The market has grown dramatically since theBritishgovernment began issuing inflation-linkedGiltsin 1981. As of 2008, government-issuedinflation-linked bonds comprise over $1.5 trillion of the international debt market.
Inflation-indexed bonds pay a periodiccouponthat is equal to the product of the inflationindex and the nominal coupon rate. The relationship between coupon payments, breakeveninflation and real interest rates is given by theFisher equation. A rise in coupon payments is aresult of an increase in inflation expectations, real rates, or both.For some bonds, such as theSeries I Savings Bonds(U.S.), the interest rate is adjustedaccording to inflation.For other bonds, such as in the case of TIPS,the underlying principalof the bond changes,which results in a higher interestpayment when multiplied by the same rate. For example, if the annual coupon of the bond was 5% and the underlying principal of the bond was 100units, the annual payment would be 5 units. If the inflation index increased by 10%, the principal of the bond would increase to 110 units. The coupon rate would remain at 5%,resulting in an interest payment of 110 x 5% = 5.5 units.
If you currently own bonds, you’ve already made a bet on inflation, whether you know it or not. Traditional fixed-income investments may not provide the real return investors needduring periods of high inflation. It’s important to know whether your traditional fixed-incomeinvestment breaks-even with inflation.