Inflation linked and floating rate bonds

Bond Types and Structures · Bonds Explained

Ask what changes

An inflation linked bond adjusts specified cash flows using a defined inflation index. A floating rate note resets its coupon using a reference interest rate and a contractual spread. An inflation index and a money market reference rate are different measurements, even when central banks respond to inflation.

Start by identifying the index, reset schedule, calculation lag, any floor or cap, and the security’s maturity. The product name alone does not tell you the complete formula.

Work through an inflation adjustment

For US Treasury TIPS, principal adjusts with the specified consumer price index and coupons use a fixed rate applied to adjusted principal. At maturity, the Treasury repays at least the original principal under its rules. That floor does not guarantee recovery of any premium you paid in the secondary market.

In a simplified example, $1,000 of indexed principal rises to $1,030. A 2% annual coupon rate would correspond to $20.60 of annual interest at that principal level. Actual payments depend on the index ratio at the relevant payment dates. This arithmetic is illustrative, not a quoted TIPS return.

Work through a coupon reset

Imagine a note that pays a reference rate plus 1 percentage point, with no binding cap or floor. A 3% reference rate implies a 4% coupon. If the reference later falls to 2%, the reset coupon becomes 3%. The contract specifies when that adjustment takes effect.

A corporate floating rate note still carries credit and liquidity risk. Resetting the coupon does not guarantee that the issuer will pay, and its price can respond to changing credit spreads.

Match the protection to the problem

Inflation linked bonds can still fall when real yields rise. Your personal spending inflation may differ from the index. Floating notes can reduce some rate sensitivity, but declining reference rates reduce income. Evaluate each security against a specific spending need rather than treating either label as universal protection.

Try it yourself

A floating note pays its reference rate plus 0.8 percentage points. The reference falls from 4% to 3.2%. What are the two coupon rates?

Show the worked answer

They are 4.8% and 4.0%, assuming the reset applies immediately and no floor or cap binds. The coupon falls even though the contractual spread stays unchanged.