What are the pros and cons of using bonds which are linked to inflation?

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I am worried that some of my bond investments are actually losing me money once I factor in inflation rates. I’ve heard about bonds that track inflation, and I’m wondering if those make more sense.
Joan

Paul Angell, AJ Bell Head of Investment Research, says:

In short, deciding if you’d like your bond investments to track inflation depends on what you’re hoping to get out of the investment.

Bonds that track inflation are called index-linked bonds, or colloquially, linkers. Some of the most common ones are offered by the UK government, called index-linked gilts, or by the US government, called US Treasury Inflation Protected Securities (TIPS). Let’s understand how they work before getting into the pros and cons.

With a regular government bond, you would buy the bond (issued at £100) for an agreed upon coupon. The coupon is the amount that will be paid to you each year as interest, so if it’s labelled as 4%, you’d be paid £4 each year (semi-annually), and then get your £100 back at the end. If it was a 10-year gilt, you’d earn £40 before platform fees.

However, if inflation is higher than 4% per annum over this period, your investment’s value diminishes, as you have less purchasing power at the end of the 10 years than when you started.

When do index-linked bonds make sense?

This is where linkers might have appeal. In this situation, your end payment would be adjusted upwards by 4% per year, thereby preserving the purchasing power of your investment. You would also receive a (smaller) semi-annual coupon payment that has also been adjusted for inflation year to year. However, this can also go the other way. The Bank of England’s inflation goal is just 2%. If this was achieved, the overall payout of the linker would be some way below the standard gilt.

Which of these methods is right for an investor ultimately depends on their goals. Coupons on linkers are lower, and inflation is not steady from year to year, so for those wanting a regular income, these are unlikely to be the best option. But, if an investor wanted to guarantee they ended up with a bit more money at the end of 10 years than they started with from a purchasing power perspective, linkers are likely to be more appealing.

On a longer-term horizon, it’s difficult to tell which will ultimately create a better return, because inflation is notoriously hard to predict, and can change quickly. In March 2023, the Office for Budget Responsibility predicted inflation levels averaging just 0.8% between 2024 and 2027. By November of 2023, that prediction had changed to 2.1% between 2024 and 2028. The latest inflation reading, for August 2025, came in at 3.8%.

It doesn’t mean that linkers are always the better call. In 2015, the inflation rate hit zero and it came close to doing so again in 2020 during the Covid pandemic, resulting in minimal returns on index-linked bonds.

What do you need to think about?

If you’re trying to decide what will give you a better return between a standard gilt and a linker, you will have to make a prediction on whether the market has underestimated the level inflation will reach over the life of the bond.

It’s also always important to consider the risks that come along with the investment. Remember, when a government is issuing lots of debt, it might mean they are already having trouble with funding.

The UK government has a high credit rating and is seen as very reliable when it comes to paying back bondholders. But if a government is issuing a lot of index linked bonds, they are taking an additional risk too, because they don’t know how much they will need to pay back to investors in the future. If inflation becomes much higher than expected for a prolonged period of time, this can become quite the headache for a nation’s finances.

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Paul Angell: Head of Investment Research