In this paper we study how the co-movement of inflation and economic activity affects real interest rates and the likelihood of debt crises. First, we show that for advanced economies, periods with pro-cyclical inflation are associated with lower real interest rates. Pro-cyclical inflation implies that nominal bonds pay out more in bad times, making them a good hedge against aggregate risk. However, such pro-cyclicality also increases sovereign default risk when the economy deteriorates, since the government needs to make larger (real) payments. In order to evaluate both effects, we develop a model of sovereign default on domestic nominal debt with exogenous inflation risk and domestic risk-averse lenders. Countercyclical inflation is a substitute with default, while pro-cyclical inflation is a complement with it, by increasing default incentives. In good times, when default is unlikely, pro-cyclical inflation yields lower real rates. In bad times, as default becomes more material, pro-cyclical inflation can magnify default risk and trigger an increase in real rates.