I am struggling with understanding the difference in yields between nominal bonds and inflation-adjusted bonds.

With inflation adjusted bond like TIPS, every coupon payment in addition to the face value is adjusted for inflation in accordance with increases in CPI. With nominal bonds like treasuries inflation is not considered when the issuer makes payments to the bond holder.

I am confused because nominal bond yields rise when the market anticipates a rise in inflation. I view that as investors simply increasing the discount rate when valuing the bond, decreasing the price of the bond and increasing the YTM.

If the above is true true, then don’t nominal bond yields already account for the market’s expected rise in inflation? How then do TIPS provide any benefit?

Maybe my misunderstanding comes from not really understanding how TIPS work? Please help!

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    $\begingroup$ They key is: ordinary bonds respond to the market's expected rate of inflation while TIPS are adjusted for the actual rate of inflation as objectively measured by the CPI. And believe me, the market's forecast of inflation can be quite different from the actual outcome (even if the Fisher Relation is true on average over the long term). $\endgroup$ – noob2 Mar 24 at 19:09
  • $\begingroup$ @noob2 Thank you! So how would say, cap rates, correlate with TIPS? Better than nominal bonds? I was told TIPS yields may be more strongly correlated with cap rates than nominal bond yields. Why would this be the case? $\endgroup$ – user3138766 Mar 24 at 19:17
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    $\begingroup$ A property investor gets income in two ways : price appreciation on the asset, and rental income. This is like owning a TIP, where you get price appreciation on the principal plus the coupon. Thus the rental income/ property price , called the cap rate, is like the tips coupon/ principal value , which is basically the real yield on a a TIP $\endgroup$ – dm63 Mar 24 at 22:37

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