A bond promises you a fixed number of dollars. Inflation decides what those dollars will buy when they arrive. This module shows you how to see through the headline yield to the real one, how much inflation can take over time, and what inflation-protected bonds can and cannot do.
Every yield you have seen so far in this course is a nominal yield: the return in dollars, with no adjustment for prices. What you really care about is what those dollars can buy. That is the real yield, the return after inflation.
Example. A bond yields 4.5% and inflation is 2.5%. Your real yield is about 4.5% − 2.5% = 2.0%. Your money grows 4.5% in dollars, but only about 2% in what it can buy.
The subtraction is a close shortcut. The exact version divides instead:
For the example above, 1.045 ÷ 1.025 − 1 = 1.95%, very close to the shortcut’s 2.0%. The shortcut is fine unless inflation is very high.
For reference, the Bank of Canada aims to keep inflation at 2%, the middle of a 1% to 3% target range. In 2022 inflation ran far above that. Canada’s consumer price index rose 8.1% over the year to June 2022, its fastest pace in about four decades. A bond paying 2% at that time had a real yield of about −6%.
Inflation compounds, just like returns and fees. A fixed amount of money buys less every year.
Example. You will receive $10,000 in 10 years. If inflation averages 3% a year, that $10,000 will buy what about $10,000 ÷ 1.03^10 = $7,441 buys today.
| Average inflation | $10,000 in 10 years, in today’s dollars | Purchasing power lost |
|---|---|---|
| 2% | about $8,203 | about 18% |
| 3% | about $7,441 | about 26% |
| 5% | about $6,139 | about 39% |
This is why “safe” money is not risk-free. A long bond or GIC that is never at risk of default can still lose a large share of its real value if inflation turns out higher than expected when you bought it.
Some government bonds are designed to protect against inflation. Their face value rises with the consumer price index, and the coupon is paid on that rising amount. You are promised a real yield, and inflation is added on top.
The market for these bonds also gives you a useful number. Compare a regular government bond with an inflation-linked one of the same maturity:
Example. A ten-year regular bond yields 3.4% and a ten-year inflation-linked bond has a real yield of 1.2%. Breakeven inflation is about 2.2%. If inflation averages more than 2.2% over the ten years, the inflation-linked bond does better. If it averages less, the regular bond does better. The breakeven is the market’s best guess of future inflation.
Inflation hurts a long bond twice. Its fixed coupons buy less, and rising inflation usually pushes interest rates up, which pushes its price down (Module 3).
Short-term bonds, treasury bills, savings accounts and short GICs suffer far less. They mature quickly, so your money is soon reinvested at new rates that reflect the higher inflation.
Example. In early 2022, a one-year GIC might have paid around 1.5%, and a ten-year bond about 2%. By early 2023, the GIC had matured and could be renewed at around 5%. The ten-year bond was still paying 2%, and its price had fallen sharply. Neither kept up with 2022’s inflation, but the short-term investor was back above inflation much sooner.
| Holding | Protection against a surprise rise in inflation |
|---|---|
| Savings account, short GIC, treasury bills | Good over time: rates reset quickly, but you earn little in real terms |
| Short-term bonds | Fairly good: reinvested within a few years |
| Long-term bonds | Poor: locked-in coupon and a large price drop |
| Inflation-linked bonds held to maturity | Good: face value rises with prices, but the price can still swing before then |
There is one more layer. Tax is charged on the whole nominal interest, including the part that only keeps up with inflation. Module 9 covers bond taxes in detail, but the effect is worth seeing now.
Example. A GIC in a taxable account pays 4%. Your marginal tax rate is 40%, and inflation is 2.5%.
| Step | Yield |
|---|---|
| Nominal yield | 4.0% |
| After 40% tax: 4.0% × (1 − 0.40) | 2.4% |
| After 2.5% inflation: 2.4% − 2.5% | about −0.1% |
A GIC that looks like it pays 4% is, in this case, slowly losing purchasing power. The same GIC in a TFSA or RRSP, where the interest is sheltered from tax, keeps a real yield of about 1.5%. This is one of the strongest reasons to hold interest-paying investments in registered accounts.
Educational purposes only; not financial advice. Any bonds, funds, tickers, rates and figures are illustrative examples, not recommendations. Interest rates, deposit-insurance limits and tax rules change, so confirm current details with the issuer, CDIC and your tax authority. Worked examples are not forecasts. Written by Elizabeta Dimoska. Always do your own research and consult a licensed advisor.