Normally when people quote a bond yield they refer to the nominal yield. The nominal yield consists of the real yield plus inflation. (So if a bond offers a 2% yield then that simply means that you get £2 for a £100 bond; if you assume inflation at 1%, then the real yield would be 1%.) So as an investor, in most bonds you have an inflation risk on top of the interest rate risk. To address this inflation concern several governments have started issuing inflation-protected bonds where the buyer is promised a real return. The inflation-indexed bonds work by linking the principal to an inflation index like the consumer price index (in the US) or the retail price index (in the UK). As those indices go up with inflation, so does the amount you are owed by the government.

The market has grown explosively since the British government started issuing these bonds in 1981, but are still not nearly as widespread as the regular bonds: there are currently about $1.5 trillion outstanding compared to world government bonds of over $40 trillion. These bonds are an interesting development and provide investors with a way to avoid the inflation risk inherent in the bond markets, and I would recommend UK and US investors in particular to consider them.

The threat of inflation is a real concern for a lot of savers and these new bonds offer a good way to address that concern. While you still take an interest rate risk and should match maturities to your maturity profile, at least your inflation risk is mitigated.

In recent inflation-linked bond issues several issuers were able to issue bonds that had a negative real interest. Think about that. You lend someone money, potentially even for a very long time, and they promise to pay you back less than what you lent them in terms of what that money can buy. It may seem crazy, but that is the reality of the world we live in right now. This does not mean that these are not good bonds to own, just an illustration that interest rates are low now and the cost of owning a bond that will be extremely likely to repay you is high.