CFAI Previous Test from 2012: Real vs. Nominal

Question

In question 6E regarding Aquiline Chemicals pension plan, the question asks if they should have real or nominal bonds for the portion of their plan that is indexed to inflation. The answer key states it should be real rate bonds because those bonds "reflect risk premium and inflation". I cannot tie this together as Nominal = Real + Inflation. So I would guess nominal bonds should be used as they include the inflation component. In all of Kaplans material, they calculate a nominal return taking into account inflation, which seems to go against the CFAI exam answer.

MockTurtle · Answer

@ShaleHill, I too am not completely clear about this. All I can say is that if you look at Table 2 on page 525 of Volume 2 of the CFAI books (this is Reading 16), it says that the assets that mimic the liability of future wage exposed to inflation are real rate bonds.

kevinpb639 · Answer

I think what you may be missing here is the fact that bonds that are inflation-indexed (eg TIPS) pay a fixed coupon on a face value that adjusts according to inflation. This means that investors do not face purchasing power erosion upon return of principal value.

In the case of a non-inflation indexed bond that pays a nominal rate of interest, in the event inflation (or expected inflation) changes, investors will continue to receive the same coupon and principal value upon maturity and it will be worth less in real terms.