Almost all bonds expose an investor to inflation risk, also known as purchasing power risk. It is a risk that the increase in inflation may wipe out the profits from the bond. I’ll take a simple example to explain this.
Let’s say you buy a 1-year $100 bond that pays 8% coupon. At the end of one year you will receive a $8 coupon and $100 of your principal. Your investment has grown to $108. That’s like a 8% return on investment. But has your purchasing power also increased that much?
Let’s look at what you could do with your $100. One year back, you could buy 1 kg of apples. That represents the purchasing power of $100. Fast forward one year, and given an inflation rate of 5%, now the same 1kg of apples will cost you $105. If you went to the shop keeper with a $100 bill, he will give you only 0.95 kg of apples.
If we compare the above with your investment, then we can say that even though your money grew by $8, out of that $5 is wiped out by inflation, and your real wealth grew by only $3.
Since most bonds pay a fixed coupon for the life of the issue, an investor is exposed to inflation risk. There are now inflation-protected or inflation-indexed bonds in which the interest and principal payments are indexed to the inflation rate. This way the inflation-indexed bonds protect the investors from any rise in the inflation rate, and thereby allow investors to maintain their purchasing power.