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What are Real Return Bonds?

This is the mechanics of how real return bonds work. Generally speaking, they're structured so that the principal amount you receive back at maturity is the inflation-adjusted equivalent of the principal amount originally invested. In addition, the interim coupon rate is a fixed rate, but is based on the ever-increasing notional principal amount. Real return bonds, therefore, offer a hedge against inflation

Let me introduce a simplified example that should make this clear. Suppose you purchased $1,000 principal amount of a 4% real return bond when it was issued at par (which therefore costs you $1,000) and, for even greater simplicity, let's assume our example bond pays interest (and adjusts for inflation) annually. Most bonds, of course, pay interest semi-annually.

Now, let's say that inflation over the next year after your purchase, as measured by the consumer price index (CPI), is 2.5%. How does this inflation affect the principal amount? And how much will your interest payments be ?

The principal amount is adjusted to account for inflation to $1,025 (inflation of 2.5% on $1,000 equals $25). If it matured right then, that's what you'd get back, which is the inflation-adjusted equivalent of the $1,000 you originally invested. But most real return bonds have long maturities, so the principal amount would just keep growing and growing as long as there is inflation.

As for your interest payments, you will still receive 4%, but the 4% will be based on the $1,025 principal amount, rather than the original $1,000. In that way, your interest income is inflation-protected as well. Calculating 4% of $1,025 gives you $41.00 in interest. By contrast, a conventional 4% bond would pay you $40.00, which would actually be worth less than $40.00 after inflation is factored out.
I did say this was a simplified example. In reality, real return bonds are continuously adjusted for inflation.
In effect, this makes real return bonds an even better inflation hedge than they might seem at first, in that the inflation protection is on a compound rather than simple interest basis, as well as protecting both principal and interest.
Many investors aim to have a certain amount of money at retirement. If you are less concerned about how much, and more concerned about what it will buy, then real return bonds are just the ticket.
If you put $1,000 into a real return bond today it will buy approximately the same amount of goods when the bond matures, regardless of what inflation is in the interim. No other bond type offers that.
You can participate in this sector in a number of ways, including buying the bonds themselves, investing in an index that owns a basket of them, or a bond mutual fund that specializes in this area.