TIPS and Inflation-Protected Bonds Explained
Inflation-linked bonds adjust their principal with a price index, which sounds like total protection — until you meet real yields, breakeven rates, and a quirk called phantom income.
How the principal adjustment works
Treasury Inflation-Protected Securities, universally shortened to TIPS, are US government bonds whose principal is adjusted in line with the Consumer Price Index. The coupon rate itself is fixed and never changes; what changes is the principal that rate is applied to. A bond issued with 1,000 of principal and a 1 percent coupon pays 10 in its first year, and if the index rises 3 percent the principal becomes roughly 1,030, so the same 1 percent coupon now pays about 10.30. Those figures are illustrative and rounded, chosen to show the mechanism rather than to represent any actual security. The adjustment compounds, so over a long holding period the gap between the original and the adjusted principal can become considerable. At maturity the holder receives the adjusted principal, and the US structure includes a deflation floor: if the index has fallen over the bond’s life, repayment is the original principal rather than the reduced figure. Indexation is applied with a lag of roughly a couple of months, simply because the index for any given month is not published until after that month has ended.
Nominal yield, real yield, and the breakeven rate
Three numbers get confused constantly here, and keeping them apart makes nearly everything else about these bonds easier. A conventional bond quotes a nominal yield, which bundles together a real return and whatever compensation the market currently demands for expected future inflation. An inflation-linked bond quotes a real yield — the return above measured inflation — because the inflation component is handled by the principal adjustment rather than by the yield. Subtract the second from the first at the same maturity and you get the breakeven inflation rate: roughly the average annual inflation rate at which the two bonds would deliver the same outcome. If realised inflation comes in above the breakeven, the linked bond does better; below it, the conventional bond does. Breakevens are watched closely as a market-based read on inflation expectations, though they also embed risk and liquidity premiums and are therefore an imperfect proxy. As of mid-September 2026 the ten-year US breakeven sat at roughly 2.3 percent, against headline CPI running at about 3.4 percent in the twelve months to August 2026 — a useful reminder that a breakeven describes what the market expects ahead, not what has just happened.
Why they can fall in value while inflation is rising
The most common surprise for new holders is watching an inflation-linked bond lose value in a month when inflation is visibly climbing. The explanation is that the bond’s market price is set by real yields, and real yields move for their own reasons. When central banks tighten policy, or when investors simply demand more real compensation for locking money up, real yields rise and the prices of existing inflation-linked bonds fall — exactly as any bond’s price falls when the yield demanded on it rises. The longer the remaining term, the larger that price move, and inflation-linked markets contain a great deal of long-dated paper, which makes the effect more pronounced than many people expect. The principal adjustment is still happening quietly in the background throughout. But over a horizon of months, a move in real rates can easily overwhelm it.
- The United Kingdom issues index-linked gilts, historically tied to the Retail Prices Index, which under reforms already announced is due to be aligned with a CPIH-based measure toward the end of this decade.
- Several euro-area governments issue bonds linked to a euro-area harmonised price index, while others link to their own national index instead.
- Canada, Australia, Japan and a number of emerging-market governments have issued inflation-linked debt of their own, with differing indexation lags and deflation rules.
- Because those details vary by country, the label inflation-linked covers a family of related but not identical instruments rather than one standard design.
Inflation protection in these bonds is a promise about the maturity date, not a promise about next month’s price.
One practical quirk deserves particular attention. In the United States, the annual increase in an inflation-linked bond’s principal is generally treated as taxable income in the year it accrues, even though the holder receives no cash for it until the bond matures. That is the origin of the term phantom income — a tax bill on money not yet in hand — and it is the main reason these instruments are so often discussed in the context of tax-sheltered accounts, where the timing mismatch does not arise. Treatment differs substantially by jurisdiction; UK index-linked gilts, for instance, sit inside an entirely different tax framework, and holding linked bonds across borders adds a further layer of complication. All figures quoted here are approximate and as of late September 2026, and yields, breakevens and tax rules all change. Tax questions in particular are worth putting to a qualified professional who knows your circumstances.
This article is educational and general in nature. It isn’t personalized investment, tax, or legal advice — always weigh your own circumstances, or talk to a licensed professional, before making financial decisions.