![]() If actual inflation turns out to be 4 percent, however, the bond's real return drops to 3 percent. But what happens if actual inflation is higher than expected inflation? An investor purchasing a conventional bond at 7 percent expects a real return of 5 percent if inflation is expected to be 2 percent during the investment period. In the real world, however, inflation is usually positive, so in most cases the real rate of return will be less than the nominal return.īecause investors understand this relationship between inflation and real returns and want, therefore, to be compensated for any decline in purchasing power, nominal interest rates tend to rise when investors expect the inflation rate to worsen, and vice versa. 1 For example, if an investor purchases a Treasury security with a 6 percent nominal interest rate, and inflation is expected to be zero during the investment period, the real expected return would be 6 percent. Investors value such protection because large increases in unanticipated inflation can eat away at an investment's real return.Įxpected inflation, real returns and nominal returns are linked by a simple relationship called the Fisher equation, which states that the real return on a bond is roughly equivalent to the nominal interest rate minus the expected inflation rate. ![]() While a conventional bond repays an investor principal plus some stated interest, an indexed bond repays principal adjusted for inflation and a fixed interest rate applied to the adjusted principal. Unlike a conventional, or nominal bond, an inflation indexed, or real, bond promises to pay its holder a fixed real rate of return-a return that is unaffected by unexpected changes in the inflation rate. SOURCE: Adopted from Campbell and Shiller (1996) What's An Indexed Bond? Indexed Bonds as a % of Total Marketable Debt Table 1 Around the World with Indexed Bonds Country of Issuance
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