Inflation-linked bonds adjust which components to reflect changes in inflation?

• A. Principal and coupon payments are adjusted for inflation.
• B. Only coupon payments are adjusted for inflation.
• C. They do not adjust for inflation; payouts are fixed.
• D. Principal is adjusted for inflation, but coupons are fixed.

Answer: (B)

Inflation-linked bonds preserve purchasing power by indexing both the principal and the interest that is paid. The principal is adjusted over time for inflation, so the amount repaid at redemption rises with inflation. Because the coupon is set as a fixed real rate applied to this inflation-adjusted principal, the actual coupon payments increase as inflation pushes the principal higher. In deflation, the principal can shrink, and at maturity you typically receive at least the original principal in many markets (often the greater of the inflation-adjusted principal and the original principal). So these bonds reflect inflation in both the amount repaid and the periodic interest payments. Describing the adjustment as affecting only the coupons would miss how the principal itself is indexed.