How are investors protected from higher inflation in an inflation-linked bond?

Inflation-linked bonds are designed to provide protection against inflation by adjusting the principal amount. As inflation rises, the principal value of the bond is adjusted upward based on changes in a designated inflation index (like the Consumer Price Index). This means that the amount of money returned to the investor at maturity is higher in real terms if inflation has increased since the bond was issued.

The adjusted principal directly impacts the interest payments, which are typically calculated based on the modified principal. Therefore, as inflation increases, investors not only see a higher principal returned at maturity, but they also benefit from interest payments that are based on this higher principal amount, thereby providing an effective hedge against inflation.

This mechanism contrasts with fixed income securities that do not adjust for inflation, where the purchasing power of returns diminishes as price levels rise. Hence, inflation-linked bonds are specifically structured to ensure that an investor's returns maintain their value in real terms even during inflationary periods.