How does inflation typically affect bond prices?

How does inflation typically affect bond prices?

• A. Inflation raises bond prices
• B. Inflation has no effect on bond prices
• C. Inflation lowers bond prices due to eroding purchasing power
• D. Inflation directly increases coupon payments

Answer: (C)

When inflation rises, the payments from a typical fixed-rate bond become less valuable in real terms, so investors require higher yields to compensate. That pushing up of required yields causes existing bonds with lower coupons to be priced down, because their fixed cash flows are less attractive compared with new bonds issued at higher rates. Since bond prices move inversely to yields, higher inflation expectations generally lead to lower bond prices. The coupons on standard fixed-rate bonds don’t increase with inflation, and inflation does affect prices, so those alternatives don’t fit.

When inflation rises, the payments from a typical fixed-rate bond become less valuable in real terms, so investors require higher yields to compensate. That pushing up of required yields causes existing bonds with lower coupons to be priced down, because their fixed cash flows are less attractive compared with new bonds issued at higher rates. Since bond prices move inversely to yields, higher inflation expectations generally lead to lower bond prices. The coupons on standard fixed-rate bonds don’t increase with inflation, and inflation does affect prices, so those alternatives don’t fit.