Inflation-linked Bonds
There are also inflation-indexed bonds, fixed-income securities linked to a specific price index. The most common examples are US Treasury Inflation Protected Securities (TIPS) and UK Index Linked Gilts. The interest and principal repayments under this type of bond are adjusted in line with a Consumer Price Index (in the US this is the CPI-U for urban consumers). This means that these bonds are guaranteed to outperform the inflation rate (unless (a) the market price has increased so that the "real" yield is negative, which is the case in 2012 for many such UK bonds, or (b) the government or other issuer defaults on the bond). This allows investors of all types to preserve the purchasing power of their money even at times of high inflation. For example, assuming 3.88% inflation over the course of 1 year (just about the 56 year average inflation rate, through most of 2006), and a real yield of 2.61% (the fixed US Treasury real yield on October 19, 2006, for a 5 yr TIPS), the adjusted principal of the fixed income would rise from 100 to 103.88 and then the real yield would be applied to the adjusted principal, meaning 103.88 x 1.0261, which equals 106.5913; giving a total return of 6.5913%. TIPS moderately outperform conventional US Treasuries, which yielded just 5.05% for a 1 yr bill on October 19, 2006.
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