How does inflation affect a bond?

Inflation erodes the purchasing power of a bond's future cash flows. Typically, bonds are fixed-rate investments. If inflation is increasing (or rising prices), the return on a bond is reduced in real terms, meaning adjusted for inflation. For example, if a bond pays a 4% yield and inflation is 3%, the bond's real rate of return is 1%.

Why do we know about inflation-adjusted bonds?

We know because the existence of inflation-adjusted bonds permits us to compute the market’s inflation forecast. For issues with the same maturity date, the yield on a conventional Treasury minus the yield on a Treasury Inflation-Protected Security equals the anticipated rate of inflation.

How do inflation-indexed bonds work?

Inflation-indexed bonds reference a market index that measures inflation, like CPI. As the index rises and falls with inflation, the value of the bond’s principal is adjusted, changing the amount you earn with each coupon payment. Let’s return to our one-year bond example.