Standard yield calculation methods still apply to inflation-adjusted bonds, only investors are more likely to pay attention to real yield?with an inflation-adjusted bond. Inflation-adjusted bonds have yields that appear to be lower than non-adjusted (nominal) bonds. The bond yields for inflation-adjusted bonds are specified as a percentage rate in excess of measured inflation.
To find the real (rather than nominal) yield of any bond, calculate the annual growth and subtract the rate of inflation. This is easier for inflation-adjusted bonds than it is for non-adjusted bonds, which are only quoted in nominal changes.
Consider the difference between a U.S. Treasury bond (T-bond) and a Treasury inflation-protected security (TIPS). A standard T-bond with a par value of $1,000 and a coupon rate of 7% will always return $70. A TIPS, on the other hand, adjusts its par value according to inflation. If inflation is 5% during the course of a year, a $1,000 par value TIPS would turn into a $1,050 par value even if the secondary market price of the TIPS declined over the same time.
A $1,000 par value TIPS with a 4% coupon would initially generate a return of $40. If inflation adjusted the par value to $1,050, the coupon payment would instead be $42 ($40 x 1.05). Suppose the TIPS were trading at $925 on the secondary market. The real yield calculation would use the secondary market price (like any other bond) of $925, but use the inflation-adjusted coupon payment of $42. The real yield would be 4.54% (42 ÷ 925).
Bonds that are linked to the consumer price index (CPI), for example, generate yields that have an embedded inflation assumption. If nominal government bonds are yielding 5% and TIPS are yielding 3% for the same maturity, the assumption is that the annualized CPI will be 2%. If actual inflation over the course of the year exceeds 2%, the TIPS bondholders receive a higher real return than nominal bondholders. That 2% threshold is referred to as the inflation break-even point, beyond which the TIPS becomes a better value than the nominal bond.