As the name suggests, in inflation-indexed bonds, the interest and principal payments are indexed to the inflation rate. This way the inflation-indexed bonds protect the investors from any rise in the inflation rate, and thereby allow investors to maintain their purchasing power.
These bonds are also called inflation-linked bonds.
For inflation-indexed bonds, the coupon bond is equal to the inflation index multiplied by the nominal coupon rate.
The Fisher equation is used to establish the relationship between coupon payments, breakeven inflation and real interest rates is given by the Fisher equation. As inflation or real rates rise, so will the coupon payments.
In the US, TIPS (Treasury Inflation-Protected Securities) are the most liquid inflation-indexed bonds.
The inflation-linked bonds are most common in UK, followed by US and France.
The inflation-indexed bonds are considered good for diversifying a portfolio containing, stocks, fixed income bonds and cash, as there is very little correlation between them.