If inflationary expectations increase, what is likely to happen to the yield to maturity on bonds in the marketplace? What is also likely to happen to the price of bonds?
Yield to maturity would be higher in case of an increase in inflationary expectation, and the bond price would fall.
Yield to maturity (also called the discount rate) is the required rate of return by the bondholders. The required rate of return or yield to maturity is determined based on the real rate of return, inflation premium, and risk premium.
As stated, yield to maturity has three factors. One of them is the inflation premium; inflation premium is the premium to compensate for the eroding effect of the inflation.
If the inflation level is high, a higher premium would be demanded, and yield to maturity would rise. This rise in yield to maturity would make the bond price fall as the present value would be computed at a higher yield to maturity.
If the inflation level were lower, the opposite effect would take place, and the yield to maturity would fall, which would give rise to an increase in the bond price.
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