[expat_panama]

... assuming that rates drop from 5% to 1%, instantly, is a bond trader going to buy a 5% bond if the "real" inflation rate is 8.5%?

Absolutely!

A $100k 1-yr bond sells for $95k when rates are 5%.  I buy it, the next day rates go to 1% and a $100k 1-yr bond is now worth $99k, which is what I sell my bond for, and I pocket a cool $4k.  In one day I've picked up a 4% return, which translates to an annual rate of 166,504,861.4%.   OK, after 8.5% inflation I'm only getting a 166,504,852.9% rate of return but hey, it's a living.

[Toddsterpatriot]

A $100k 1-yr bond sells for $95k when rates are 5%. I buy it, the next day rates go to 1% and a $100k 1-yr bond is now worth $99k, which is what I sell my bond for, and I pocket a cool $4k.

No, no, no! It sells for $100k and rises to $104k.

In one day I've picked up a 4% return, which translates to an annual rate of 166,504,861.4%.

Your example is a 4.2% return, mine is a 4.0% return, 164,880,328.5% annual return, funny man!