While US Treasury bills, notes, bonds and strips are crucial components of the bond investment universe. They share a key limitation. They lack direct inflation protection. The principle repaid by the bond issuer remains the same from issue to maturity, which means that high inflation over the bonds lifespan can erode the purchasing power of the investment. Although investors can forecast inflation and incorporate this into their desired yield, there is no guarantee of what future inflation will be on the date a bond is purchased. Inflation linked bonds such as treasury inflation protected securities TIPS in the US are designed specifically to address this inflation risk. TIPS are an attractive option for investors looking to safeguard their investments from inflation's impact of eroding purchasing power issued regularly, and in response to investor demand with initial maturities of five, 10, and 30 years, TIPS offer long-term inflation protection by adjusting their face value based on changes in the consumer price index or CPI. Let's take a closer look at how TIPS conceptually provide inflation protection. TIPS are classified as principle linked bonds. When TIPS are issued, they come with a fixed coupon rate, similar to regular fixed coupon bonds. However, in addition to this, fixed coupon TIPS investors have a second source of income, the inflation adjustment. This is provided through adjustments to the bonds principle based on changes in the CPI and here is how it works. The face value of TIPS are regularly adjusted to reflect changes in the CPI. If inflation occurs, the face value of the bond increases in the case of deflation, the face value decreases. This adjustment ensures that the bond's face value keeps pace with inflation preserving the purchasing power of the investment.

Although the coupon rate on TIPS remains fixed, the actual dollar amount of each semi-annual coupon payments fluctuates based on the adjusted principle. Since the face value rises with inflation, the coupon payments which are calculated as a fixed percentage of the adjusted principle also increase in periods of rising prices.

When TIPS reach maturity, investors are repaid the greater of the inflation adjusted principle or the original face value. This feature known as a deflation flaw ensures that investors won't receive less than the bond's original power amount, even if deflation has occurred over the bonds lifespan. Not all inflation linked bonds offer this protection. For example, the UK's index linked Gilts do not have a deflation flaw, meaning their maturity value could be lower than the original face value in prolonged deflationary periods. This distinction is important for investors to consider when comparing inflation linked bonds across different markets.

Bonds with a deflation flaw like US TIPS provide an additional layer of security against the risk of declining price levels, making them a more stable choice for those concerned about potential deflation. By adjusting the face value of the bond with CPI changes all principle linked bonds help safeguard the purchasing power of the original investment. This makes them particularly useful for those with long-term investment horizons who want to mitigate the impact of inflation on their portfolios.