Fixed-income assets are affected by inflation, which reduces their buying power and lowers their actual returns over time. Even if the pace of inflation is minimal, this can occur. If your portfolio earns 9% and inflation is 3%, your real returns will be around 6%. Because they increase in value during inflationary periods, inflation-index-linked bonds can help to mitigate the risk of inflation.
Inflation Indexed Bonds are bonds where the principal is indexed to inflation. They are thus designed to cut out the inflation risk of an investment. In the current Indian context, the bonds would be issued and traded at a ‘Real yield’ and the principal of the bond would be adjusted to the Wholesale Price Index (WPI).
For eg. The IIB issued issued at a ‘Real’ Yield of 2.5% which will be fixed for the life of the bond and the regular interest payments would then be (2.5% * (Adjusted Indexed principal/100). This adjusted principal would be determined from the WPI Index. So as the WPI index increases due to inflation, the actual interest payments would be higher as the Adjusted Principal would also increase.
So, while the interest rate remains fixed at 2.5% per year, the nominal value of each interest payment will rise, as the coupon will be paid on the inflation-adjusted principal value