Floating-rate and inflation-linked bonds explained

In plain language — An FRN resets its coupon using a reference rate. An inflation-linked bond ties principal or payments to a price index. Each narrows one mismatch, but neither removes every risk.

Floating-rate notes (FRNs) reset coupons using an index plus a contractual spread. Inflation-linked bonds adjust principal, coupon or both through price-index rules. The mechanisms differ: an overnight rate can respond quickly to monetary policy, while a price index follows its own publication calendar and lag.

Floating-rate notes: reset is not instantaneous

A simplified coupon rule is:

Coupon rate = reference index + contractual spread

Documents specify index, observation date, lookback or lockout, reset frequency, payment period, day count, cap and floor. U.S. Treasury FRNs, for example, mature in two years, pay quarterly and use an index rate plus a spread fixed at auction, under TreasuryDirect rules.

When the index rises, a future coupon tends to adjust, but observation, reset and payment are separated in time. Price can still move because of issuer spread, liquidity, rate expectations, caps or floors, and differences between the contract index and actual funding cost. Rate duration is often shorter than that of a comparable fixed-rate bond, not necessarily zero.

Inflation-linked bonds: nominal and real

For U.S. TIPS, principal is adjusted by the consumer-price index under a lagged procedure and the fixed coupon rate applies to adjusted principal. At maturity, TreasuryDirect describes nominal principal protection under the product rules. Other countries and securities can use different indices, lags, floors and tax treatment.

A simplified reading separates nominal and real yields:

Break-even inflation ≈ nominal yield − real yield

Observed break-even inflation is not a pure forecast. It may include risk and liquidity premia, supply-demand effects, seasonality and technical differences. The official index may also differ from an individual's spending basket.

Deflation can reduce indexed principal during the bond's life; floors and final redemption depend on the contract. A buyer above par can still lose relative to purchase price or market value.

Operational comparison

For an FRN, map fixing and payment dates, index source, spread, caps, floors and fallback. For an inflation-linked bond, map index, lag, index ratio, base index, interpolation and floor. Both calculations must reconcile clean price, accrued interest and cash flows.

Scenario analysis separates nominal curve, real curve, inflation expectations, credit spread and liquidity. A resetting coupon does not protect against default; indexed principal does not guarantee a positive real return after price, tax and costs.

Both structures retain basis risk: the contractual index can move differently from the economic exposure being hedged. Benchmark modification or cessation depends on fallback terms.

Common error — Calling an FRN “free of rate risk” or an inflation-linked bond “complete inflation protection.” Both statements ignore resets, basis, price, credit and contract terms.

Questions this page answers

Which index determines cash flows? With what lag and frequency? Are there spread, cap or floor terms? Which principal is redeemed? Does price still reflect credit and liquidity? Does the index match the exposure?