Bond yield is theoretically an aggregate of real rate of interest and expected inflation. This study verifies this relationship empirically for the bond markets of USA and India using bond yield data for long-term securities against the expected inflation for the period 1996-2002. A linear regression technique is used to determine the extent of relationship between the variables of bond yield and expected inflation. The results show that Indian markets have also started to reflect the expected inflation dependency which has been the hallmark of developed markets of USA, Canada, etc. Earlier period data (1991-96) for Indian bond market does not show any significant relationship between nominal yields and expected Inflation. The results could lend credence to the reforms initiated by RBI in that it has led to expanding the market thereby making it more independent in determination of yields as per expected economic realities. Bond markets in India have witnessed active trading in the last six to seven years. This is attributed to reforms initiated by RBI from 1997-98 onwards.

Till then the yield was not seen to be representative of the real market conditions (inflation being the major one of them). Fischer in his famous equation defined the yield on bond to be an aggregate of real rate of return and the expected inflation. This paper is an attempt to empirically test if expected inflation (as measured by moving average of past inflation) determines the yield on a government security, for the Indian market. To empirically test such a relationship would require the data for the real rate. This is not a problem in the developed markets of UK, Canada and USA where index bonds have been introduced in the years 1981, 1991 and 1997 respectively. By their very nature these bonds eliminate most of the risk associated with uncertain inflation. The return given by these bonds thus reflects the real rate of return to the investors. In Indian markets however no such instrument is available and this impedes any study involving real rate of return. This problem is resolved here by taking the difference of the yield and inflation as the real rate of the return. In order to have a benchmark with which to compare the results, we do a simultaneous study for the bond markets of USA. For the USA markets the study takes the data for long-term treasury securities. The inflation is as measured by CPI. This data is collected for the period 1996-2002. For India the bond yield data is taken from RBI website which gives the average yields for short-term, medium term and long-term securities. Here again its association.A study done by Williams for the USA market (The information content of treasury inflation indexed securities, Nov-2000) has however concluded that methods to estimate inflation expectations from Treasury inflation index securities must however consider the institutional features of inflation indexation, risk and illiquidity premiums, tax considerations, and appropriate duration adjustments.

Dudley et al (1996) have analyzed in considerable detail the value of indexed bonds as a guide to future inflation. They have argued in their paper that difference between the yields on nominal and indexed bonds would be distorted by random fluctuations in the demand for different kinds of bonds. This is so because the yield on a bond is being also determined by the demand and supply of the bonds. With the demand and supply dynamics influencing the yields it would be difficult to segregate its effect and get a true inflation expectation measure.

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