Inflation and Interest Rates: Real vs. Nominal Rates

Inflation reduces the future purchasing power of coupon payments. 
It often leads to higher interest rates, which in turn causes bond prices to decline due to the inverse relationship between interest rates and bond prices.
Understanding how inflation impacts bond pricing requires familiarity with nominal and real returns. 
Nominal return refers to the percentage increase in investment value without accounting for inflation. 
Real return reflects the actual increase in purchasing power after adjusting for inflation.
For example, Alex invests one hundred dollars in a bond with a nominal return of ten percent. After one year, Alex’s bond investment grows to one hundred and ten dollars. 
However, with an inflation rate of four percent, the real return accounts for the reduction in purchasing power. 
The real return calculation shows that Alex’s purchasing power increased by approximately five-point eight percent after accounting for inflation.
Investors must understand how inflation affects interest rates. This relationship impacts bond pricing and actual returns, particularly for long-term savings or retirement planning.