An index-linked bond promises a real return. The mechanism is a single multiplier applied to principal, and once you have the multiplier every other number follows.
How is the index ratio calculated?
The index ratio on any date is the reference index level for that date divided by the reference index level at issue. Multiply the original principal by the index ratio and you have the inflation-adjusted principal.
The stated coupon rate is a real rate, fixed for life, and it is applied to the inflation-adjusted principal rather than to the original principal. The cash coupon therefore rises and falls with the index while the real rate never moves.
Take a five-year linker on original principal of $1,000,000 with a real coupon of 1.500% and a reference index of 300.000 at issue. If the index runs +3.0%, +2.0%, then falls 6.0% and 3.0%, then recovers 1.5%, the index ratios are 1.030000000, 1.050600000, 0.987564000, 0.957937080 and 0.972306136, and the cash coupons are $15,450.00, $15,759.00, $14,813.46, $14,369.06 and $14,584.59. Nothing about that sequence is a surprise once the ratio is in front of you, and the deflation years produce lower cash coupons for exactly the reason the inflation years produced higher ones.
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What is the deflation floor?
The deflation floor is where instruments differ and where most errors get made. A United States Treasury Inflation-Protected Security repays, at maturity, the greater of the inflation-adjusted principal and the original principal. In the path above the adjusted principal at maturity is $972,306.14, so the floor binds and the holder receives $1,000,000.00. That protection is worth $27,693.86, or 2.769386% of original principal, and on a par purchase it is the difference between a nominal money return of 1.50045230% and one of 0.95673684%, which is 54.3715 basis points of yield delivered by a single clause.
The floor protects principal at maturity. It does not protect the coupons. Every coupon in the deflation years was computed on the unfloored adjusted principal, and applying the floor to the coupons too would have paid $76,209.00 rather than $74,976.11, a difference of $1,232.89 the holder does not receive. A learner who applies the floor to the coupon stream will overstate the cash flows of every linker they ever model, and the error is invisible unless the index actually falls.
How do index linked bonds work in practice?
India has issued inflation-indexed bonds and inflation-indexed national saving securities on a comparable mechanism, using the wholesale price index and later the consumer price index as the reference. Issuance has been intermittent. The current status, the reference index and the indexation lag are all the kind of detail that has to be read out of the Reserve Bank of India's own issuance documents rather than assumed (check the current status and reference index with RBI).
The indexation lag is the one mechanical wrinkle worth carrying. A price index is published with a delay, so the reference index applied on a settlement date is a published level from some weeks earlier, usually interpolated between two monthly readings.
A linker therefore does not track this month's inflation. It tracks inflation as measured a couple of months ago, and in a fast-moving month that is a real difference rather than a rounding one.
Breakeven inflation, meaning the difference between a nominal yield and a real yield of matched maturity, is the signal most people actually use linkers for. It is read as a macro indicator rather than as an instrument feature, and it belongs with the material on what the curve's level and shape say about the economy.