pays $3 in interest each year. Hence, the nominalyield of the bond is 3 percent.
The real (inflationadjusted) yield is also 3 percent because the realcash flow and the nominal cash flow are equal whenthere is no inflation.In the second scenario, inflation is assumed to be4 percent, but there is still no uncertainty aboutinflation. Because inflation erodes the purchasingpower of nominal payments, the relevant yield toexamine is not the nominal yield, but the real yield.The real yield
that corresponds to a nominalyield
when the actual inflation rate
is knownis given by the Fisher identity:
r = i - p
, which statesthe real yield equals the nominal yield less theinflation rate.
In this case, to keep the real yield onthe nominal bond at 3 percent, the same as underthe no-inflation scenario, the nominal yield on thebond has to rise to 7 percent
(i = r + p = 3 + 4)
.Thus, with positive inflation but no uncertaintyabout its level, bond issuers simply raise the nomi-nal coupon rate to 7 percent so that the real yield toinvestors (and real cost to issuers) remains the sameas in the zero-inflation scenario.
In the real world, however, inflation uncertaintycreates a risk for both investors and issuers. When-ever actual inflation differs from what was ex-pected, the real yield of the bond also differs fromwhat was expected. In the third scenario, actualinflation doubles to 8 percent soon after the bond isissued and remains steady for the life of the bond.In this case, investors lose since the real yield of thebond becomes a
1 percent (7 - 8 = -1),which is much less than the 3 percent expected byinvestors. By contrast, in the fourth scenario, actualinflation drops to 2 percent after the bond is issuedand remains steady. In this case, issuers lose sincethe real yield, and thus the real cost of servicing thebond, becomes 5 percent (7 - 2 = 5), which is muchmore than the issuers were prepared to pay.These last two scenarios illustrate the inflationrisk of nominal bonds. While the nominal yield of a bond can be adjusted to account for expectedinflation at the time the bond is issued, the bond’sactual real yield varies with actual inflation, whichcan be quite different from what was expected. If actual inflation rises unexpectedly, the real ratefalls; and if inflation declines unexpectedly, the realrate increases. Because it is impossible to knowwith certainty the actual rate of future inflation,inflation risk is intrinsic to nominal bonds andcannot be eliminated.In contrast to nominal bonds, inflation indexed orreal bonds have no inflation risk. By design, thenominal cash flow of a real bond is adjusted by thecumulative rate of inflation to insulate its real cashflow, and therefore its real yield, from changes ininflation. In other words, while a nominal bond’scash flow and nominal yield are adjusted by ex-pected inflation when the bond is issued, the couponpayments and maturity value of a real bond areadjusted over the entire life of the bond. The adjust-ment is made after inflation occurs to achieve thereal yield that investors and issuers agreed upon atthe time of issuance.Table 1 shows why indexed bonds have no infla-tion risk even when actual inflation differs fromwhat was expected. The table shows the real andnominal cash flows of a 10-year, $100 indexed bondthat has a 3 percent coupon rate under the fourinflation scenarios discussed above.
The real cashflow is shown just once since it is the same regard-less of the actual level of inflation. Notice that wheninflation is zero, the nominal cash flow and real cashflow of the indexed bond are exactly the same. Asinflation rises, both the nominal coupon paymentsand maturity value rise to maintain the 3 percentreal yield.
While indexing insulates all bonds from inflationrisk, the advantage of indexing is greater for long-term bonds than for short-term bonds, due mainlyto differences in inflation risk. Inflation risk forlong-term nominal bonds is significant, while infla-
42FEDERAL RESERVE BANK OF KANSAS CITY