Because the purchasing power of your dollar decreases over time as a result of inflation, the rate at which your investments grow must exceed the inflation rate in order for you to experience real gains. Straight bonds pay their interest on a fixed principal amount. The principal amount is repaid at maturity. By the time this happens, this amount will not be worth as much in "real" dollars as it was when you first invested it. Inflationary risk is a major concern for investors of regular bonds because the purchasing power of the principal will decrease over time.
An inflation-adjusted security remedies this problem by adjusting the dollar value of the bond's principal to inflation. The bond increases its principal by an amount based on the non-seasonally adjusted CPI-U. The inflationary level when a bond is first issued is known as a bond's reference CPI-U. Because inflation for a given month is not actually known until two months later, a bond's reference CPI-U is the same as the CPI-U three months before the bond is issued. To arrive at the bond's inflation-adjusted value, the bond's principal is multiplied by the CPI-U index ratio (the current CPI divided by the bond's reference CPI).
For example, you buy a 10-year, $1,000 Treasury inflation-adjusted bond in April. The CPI reference rate is taken from January's CPI (three months earlier), which is 100. Six months later, inflation has risen 1% and the current CPI is now 101. This gives you a CPI index ration of 101/100, or 1.01. Your bond's principal is now worth $1,010, or 1,000 x 1.01.
At its maturity, the bond pays either the inflation-adjusted principal or the original principal amount, whichever is higher. The bond's semi-annual interest payments are calculated with a fixed rate of interest on its inflated principal, guaranteeing that the investor earns, on the original investment amount, a rate of return higher than inflation. The interest rate of the bond is established at issue.
Characteristics of Inflation-Adjusted Securities >>