What are inflation-linked bonds and how do they work?
Most inflation-linked bonds are bonds issued by sovereign entities. Unlike conventional bonds, their coupons and final payment are linked to realised inflation, as measured by the price index of each market. This link helps investors hedge the risk of inflation on their portfolios. But how so?
Inflation can erode the real returns investments bring, as the pricing power of one euro, pound or US dollar changes with the rate of inflation over time. Inflation cannot be observed directly but is estimated using price indices, based on subjective baskets of goods and services. These baskets evolve over time as products on the market and consumers’ interests change.
At a continuous inflation rate of 2% over two years, €1.00 is worth €1.04 two years later. As with an ordinary bond, the investment is made at purchase, none of this inflation uptick is being transferred into our investments.
At maturity, this means that, due to inflation, the monetary value of a €1,000 investment would only be able to purchase goods and services of the amount of €961.17 – the higher the inflation rate and the longer the investment horizon, the more inflation will erode your purchasing power at maturity of the bond.
Hedging the inflation impact
To hedge the inflation risk, investors can buy inflation-linked bonds instead. These bonds have a set interest rate – if lower than those of comparable ordinary bonds – but benefit, in addition, from an adjustment of the bonds’ principal according to the measure of inflation throughout the bonds’ life. For bonds issued by Eurozone members, that usually is the Harmonised Index of Consumer Prices (HICP) excluding tobacco, for the UK the Retail Price Index (RPI) and for the US the Consumer Price Index (CPI). But what does that mean?
Our €1,000 investment will be adjusted according to the current rate of inflation throughout the life of the bond. If inflation, as in our previous example, stays at a continuous rate of 2%, at maturity the principal is worth €1,040.40. And this would be what investors receive from the issuer of the bond – not just the €1,000 invested, all else equal.
In addition, the interest during the bond’s lifetime is computed on the inflation-adjusted principal, so at a coupon of 1.5% the return is €30.91 over two years compared with the €30.00 of a usual bond at 1.5%.
Figure 1 - Source: AXA IM. Blue arrows correspond to real value, purple to inflation-linked indexation.
Should deflation occur, then the interest paid on the inflation-linked bonds reduces by the amount of deflation – apart from in the case of Australian linkers, where coupons are protected.
However, most sovereign issuers offer protection of the principal against deflation at maturity, through a floor at par value. This effectively protects the sum invested at the time the bond was issued against deflation. The only sovereign exceptions for this are the UK (for some old issuance) and Canada.
Relative value and break-even inflation
To consider the attractiveness of an investment in inflation-linked bonds, investors like to compare the bonds with the conventional (or nominal) bonds of the same issuer. The interest rate of a nominal bond is listed on the face of a bond, this is also known as the nominal yield of a bond. The real yield of a bond refers to the nominal yield minus the rate of inflation. This means that, while the yield listed on your bond might say your interest is 3% (nominal yield), if inflation is 2% you are effectively only receiving 1% of real yield.
Another important measure is the rate of breakeven inflation. This relates to the difference between the nominal yield of a nominal bond and that of an indexed bond with equivalent maturity issued by the same government. As already mentioned, the nominal yield of an inflation-linked bond is often lower than that of a nominal bond, as an additional amount of interest is related to the inflation rate. By calculating breakeven inflation, investors receive an inflation rate that must be achieved over the life of a bond, in order that the indexed bond equals the nominal bond.
Here an example of how one-year breakeven inflation levels have moved in the US, UK and Europe over the past 10 years.
Figure 2 – Source: Bloomberg, data as of 29 May 2020.
The breakeven inflation rate can, in theory, be divided in two main components:
- Inflation expectations: these cannot be calculated exactly. However, central banks’ inflation targets may be considered as benchmark values. It is noteworthy that market inflation expectations may be either lower or higher than this objective, according to market conditions and macroeconomic factors.
- Inflation risk premium: this corresponds to “friction” linked to supply and demand on the market as well as the liquidity premium.
The concept of carry, or how to generate tactical investments
The concept of breakeven inflation rates comes into play when considering the long-term yield of an inflation-indexed bond as well as the annual expected rate of inflation. From a tactical point of view, when buying and selling a bond over a shorter period, carry is a key factor: it represents the gain or loss that investors bear over their investment period depending on whether they choose to retain the security (in this case the inflation-indexed bond) or to invest in a risk-free security.
In simple terms, when comparing a risk-free security with the same maturity as the inflation-linked bond, carry reflects the gain or loss realised on the coupons in the case of positive or negative inflation, respectively. Whatever the inflation index used as a benchmark for the bond, the structure of inflation-linked bonds cannot be based upon a snapshot inflation rate.
Indeed, as gathering price information is a fairly lengthy process, it is essential to take into account this gap between the publication of the index and the period that it covers when evaluating the inflation-linked bond – for instance, the value of a price index for the month of July, will not be published until sometime in August.
In addition to the timing of the publication of the index and the payment dates of the coupon, seasonal variations also play a role. Seasonality is a modification of behaviour patterns in prices and economic activity at certain times of the year. It may be prompted by natural factors (seasons, climate, etc.), by legal measures (controlled price hikes, modification of the tax regime, retail sales periods, etc.) and cultural behaviour (Christmas, summer holidays, etc.).
The HICP excluding tobacco, which is the benchmark index for European inflation-linked bonds, exhibits a high level of seasonality. The four countries representing up to 80% of the index – Germany (26%), France (20%), Italy (18%) and Spain (12%) – exhibit similar characteristics: a high level of negative seasonality in January and July but positive seasonality during spring.
Inflation-linked bonds make up a market of over $3trn of bonds in developed markets and over $500bn in emerging markets.
The largest issuer of inflation-linked bonds is the US. As of 30 April 2020, the country had $1.35tn worth of inflation-linked bonds outstanding – with the majority of them of a remaining duration of 10 years.