Why is inflation bad for bonds?
Inflation is a rise in prices. With inflation, each dollar buys less–the purchasing power of a dollar is said to decrease. In the same way, inflation lowers the purchasing power of a non-inflation-indexed bond.Inflation RiskConsider this example. An investor buys a one-year bond that has a coupon rate of 6 percent. During the course of the bond’s life, the inflation rate is 10 percent. Because the bond’s coupon rate is lower than the inflation rate, the purchasing power of the investor’s bond (and thus its value) will have declined over its one-year lifetime.DeflationAlternatively, if the inflation rate is negative–in other words, if there is a deflation–then the value of the bond will increase above and beyond its coupon rate. So in situations of deflation, the bond investor will benefit, while in situations of inflation, the bond investor will suffer.Interest Rate RiskInterest rate risk is a different type of risk that bond investors face. However, interest rate risk is related to
