Which risk is characterized by the possibility that returns from bonds will not keep pace with inflation?

The characterization of the risk that returns from bonds will not keep pace with inflation is known as inflation risk. This risk is crucial for bond investors because the purchasing power of the income generated from bonds can decrease if inflation rises. Essentially, if the rate of inflation exceeds the nominal return on a bond, the real return (which is adjusted for inflation) could become negative. This means that even though an investor may receive regular interest payments and eventually get their principal back, those payments may not buy as much in the future due to the erosion of purchasing power caused by inflation.

Bonds are often considered safe investments, but if inflation is not accounted for, they can lead to losses in real value over time. Investors seek instruments that can provide a return that at least matches or exceeds inflation to preserve the value of their investments. Thus, understanding inflation risk is vital for making informed decisions in the debt and money markets.