Linkers versus nominals

  • Written by 

    Olivier Asselin, Q3 2015

  • 08/07/2015

Protection from inflation is a key concern for many investors. As most countries are now out of recession but with very accommodative central bank policies still in place (both monetary and liquidity policies), inflation is returning to the forefront of many investors’ minds.

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Residents of the United States, please read this important information before proceeding

Please read this important information before proceeding.

The purpose of inflation-linked bonds is to ensure the preservation of purchasing power by directly linking returns to inflation for the bond’s entire life. While there are a number of factors that need to be taken into consideration when valuing inflation-linked bonds, inflation and real interest rates are the two most important, and should be used to determine whether or not it makes sense to invest in them.

The breakeven rate

Different markets use different inflation indices. For government bonds in the US, the Consumer Price Index (CPI) is used, while in the UK, it is the Retail Price Index (RPI). In the euro area, most government bonds use the Eurozone Harmonized Index of Consumer Prices ex tobacco (HCPIx) and the differences between sovereign bond issuers arises mostly from differing sovereign credit quality.

If investors want to compare the relative attractiveness of an inflation-linked bond to that of a conventional bond with the same term, it is typical to use the breakeven inflation rate – a measure that makes the investor indifferent to owning a conventional bond or an inflation-linked bond.

The outcomes

Figure 1 shows that there are four possible outcomes if both interest rates and inflation are taken into account. As index-linked Gilts, TIPS (Treasury Inflation-Protected Securities) and other similar inflation-linked securities are ultimately bonds, they benefit in an environment of falling yields, and tend to suffer when yields are rising. This is particularly apparent as their low coupons mean they typically have a greater duration than a conventional bond of the same maturity. However, the bondholder benefits from being paid actual inflation on a slightly lagged basis. As a result, a higher inflation environment is clearly more beneficial than a lower inflation environment.
Consequently, the optimal time to own inflation-linked bonds is in a ‘stagflationary’ scenario whereby inflation is high and real yields are also high and expected to fall. This is because the investor not only benefits from falling yields (bottom right quadrant, Figure 1), but also benefits from an additional kicker in the form of inflation compensation too.

In two of the four scenarios the investor should be indifferent as to whether or not they own inflation-linked securities. This is due to the fact that while the investor might benefit from either falling interest rates or from higher inflation, these benefits are largely offset by falling inflation or rising yields, respectively.

The final scenario is the worst case for the holder of inflation-linked bonds. The investor suffers from owning a bond in a rising interest rate environment from very low, or even negative levels, yet does not benefit from compensation through inflation as it is either absent, or remains very low (top left quadrant, Figure 1).

FIGURE 1: The four possible outcomes if both interest rates and inflation are taken into account

Where does that leave investors today? Figure 2 shows the current market conditions for the key indicators of 10-year sovereign debt issues by the US, UK and Germany, looking at both inflation-linked and conventional bonds.

FIGURE 2: Current market conditions for the key indicators of 10-year sovereign debt issues

Although the current weakness in global inflation is largely a result of extremely weak commodity prices, this is not expected to be a long-term phenomenon, and so a ‘deflationary’ world is likely to be avoided. Indeed, recent inflation figures appear to confirm this and have rebounded in recent months, albeit from depressed levels. So far, the extremely easy monetary and liquidity policies appear to be working and inflation expectations have been rising in response.

So far, this pick-up in inflation is welcome, returning it to levels that central banks deem to be sustainable over the longer term. However, with the return of inflation to more normalised levels comes the risk of more hawkish central bank policy. Consistent with this view, there is significant discussion around when the Federal Reserve and the Bank of England will start hiking interest rates.

As we have discussed above, rising yields will not benefit index-linked bonds, and Figure 2 shows how low real interest rates are currently. Normalisation of monetary policy would result in these rates rising considerably. However, inflation will offset the negative effects of rising interest rates to a degree. The question here is: how much does the investor need to consider the breakeven rates? While inflation is likely to return to these levels, it is unlikely to materially exceed the current breakevens in the immediate future, and thus the case for inflation-linked bonds is not meaningfully appealing until further signs of inflation risk start to materialise.