Editor’s note: This article was first published in April 2011, and its market data is from early 2011, including euro-denominated inflation-linked government debt of over 420 billion euros and only four euro-area issuers. Much of this has changed, and Spain, for instance, later began issuing.
A few weeks ago we discussed investing in inflation-linked bonds as a profitable type of investment in times of crisis. Now Morningstar gives us a good explanation of what these bonds are, how they work, how they differ from other types of bonds, and who their main issuers and investors are.
Inflation is a sustained rise in prices across an economy that affects consumers’ purchasing power. It is especially harmful for fixed-income investors, because it erodes the value of their investments and reduces real returns.
For example, if a five-year bond paid an 8% coupon and inflation stood at 6% over the same period, the bond’s real rate of return would be just 2%. Inflation-protected securities, however, can act as a hedge against the loss of purchasing power that fixed-income investments such as bonds may suffer when inflation is rising. Below we look at these securities in more detail.
The instrument
What is an inflation-linked bond?
An inflation-linked bond (ILB) pays interest at fixed intervals and repays the principal at maturity, just like a conventional bond. However, the interest rate and the value at maturity are adjusted for the rate of inflation over the life of the bond. Index-linked bonds make payments that are fixed in real terms, which is why they are also called real bonds. The real rate of return is known in advance, while the nominal return varies with the rate of inflation recorded over the life of the bond.
How does it work?
ILBs are linked to the cost of consumer goods, such as the consumer price index (CPI); each country uses a different method to calculate this index regularly. Each country also has its own body that issues inflation-linked bonds. In the US, for example, TIPS (Treasury Inflation-Protected Securities) are linked to the US CPI and sold by the Treasury Department. In the United Kingdom, inflation-linked government debt is issued by the UK Debt Management Office and linked to the country’s Retail Price Index (RPI), and so on.
In general, every country issues ILBs whose principal rises with inflation. So when inflation goes up, so does the bond’s face value. This contrasts with nominal bonds, which lose value when inflation rises. In addition, when the face value is adjusted to the price index, the interest the bond pays is also adjusted for inflation. Thanks to these features, ILBs are able to cancel out the real impact of inflation.
How does it differ from a nominal bond?
The coupon on an ILB is adjusted for the rate of inflation, unlike the interest paid by a nominal bond. With a nominal bond, the purchasing power of fixed nominal cash flows is eroded by inflation, which exposes investors and issuers to the risk of changes in the inflation rate, something that doesn’t happen with inflation-linked bonds.
What is the break-even inflation rate?
The break-even inflation rate is the difference between the nominal yield on a fixed-rate investment and the real yield on an inflation-linked investment with a similar maturity and credit quality. In other words, it is the hypothetical rate of inflation at which the expected return on the two bonds would be the same. The break-even inflation rate therefore gives an indication of expected average inflation over the life of the bond.
The market
How large and mature is this market?
ILBs first appeared in the 18th century to counter the corrosive effect of inflation on the real value of consumer goods, such as beef, eggs, clothing and other basic necessities, during periods of rising prices. The Massachusetts Bay Company began selling these bonds in the 1780s, but at the time few investors took an interest. However, after the rapid economic expansion that followed the Second World War, the idea of bonds linked to inflation caught the attention of public-sector financial managers. Iceland, for instance, issued inflation-linked bonds in the early 1950s to fight the high inflation caused by the rapid growth of its GDP. Thirty years later, in the early 1980s, the modern ILB market really took off when the United Kingdom issued “linkers”, as these bonds are often called there. Other countries followed suit, including Sweden, Canada, Japan and Australia. The US did not fully return to the ILB market until the Treasury began issuing TIPS in the late 1990s.
Who are the main issuers and investors in this market?
Governments have been the main players in the markets for inflation-linked securities for 20 years: the euro-denominated government debt market currently totals more than 420 billion euros, and the British index-linked debt market exceeds 384 billion dollars.
Besides growing issuance, the inflation-linked market is also growing in number of issuers (Germany was the last G7 country to enter this market) and maturities (with issues of up to 50 years). Inflation-linked bonds are also issued by companies whose revenues are directly exposed to inflation, such as property companies and electricity utilities. Even so, the market for corporate ILBs is still tiny compared with that for government ILBs.
Demand for ILBs is driven by pension funds, which need to make sure that their returns won’t be eroded over the long term and are looking for indexation alternatives that use less capital. Studies have also concluded that it is beneficial for governments to have part of their debt linked to inflation, for the sake of diversification and to match the inflation-linked nature of their revenue sources. ILBs also attract investment funds (for the diversification benefits this asset class offers), insurers that need stable returns, and individuals who want to lock in fixed real returns.
How will this market develop?
The ILB market is expected to keep growing over the next few years. While the US and the UK account for a large share of total issuance of this type of debt, the European market is still relatively limited, with only four issuers (Germany, France, Italy and Greece). More issues are expected from countries such as Germany, which entered the ILB market relatively late. There is also talk that Spain and the Netherlands could start issuing ILBs. The situation is different in Japan, where inflation has been very low or even negative in recent years. In fact, the country’s Ministry of Finance is clearing out its inflation-linked government debt market by buying back these securities.
The asset class
Why invest in inflation-linked bonds rather than other instruments that protect against inflation?
Inflation is generally the biggest enemy of a fixed-income investor, so inflation-linked bonds are a natural solution. Because their coupons and principal are indexed to consumer prices, and because they are usually issued by stable, creditworthy countries, inflation-linked bonds have a proven track record as an effective, low-volatility protection against rising prices. They also show a negative correlation with risk assets, which is particularly useful for diversifying a portfolio.
Other investments can insulate a portfolio from inflation-related risks, but they all tend to carry a larger speculative component. Property, for example, is more volatile and also less liquid. Similarly, gold has shown a close correlation with inflation over the long term, but the growing weight of speculators in setting its price means it isn’t a risk-free solution either.
Equities are also seen as good protection against inflation. Shares in natural resources, tobacco, food and pharmaceutical companies are popular with investors for this reason. However, their results can vary widely over shorter periods, and they are also more volatile.
Why choose global rather than domestic inflation protection?
Inflation is a global phenomenon, and the correlation of CPI data over the past 30 years is extremely high. Investing in inflation-linked bonds from a global perspective offers three key advantages:
- A wider range of opportunities makes it easier to exploit valuation anomalies and hedge against inflation using a combination of the cheapest markets available. For example, at the end of January 2011 Japan’s five-year break-even rate was 0.5% (pricing in deflation of 0.5% in each of the next five years). Since the equivalent break-even rates in the US stand at 1.9%, while current inflation there is 1.5%, Japan and the US are attractive markets compared with Europe.
- A global approach also offers obvious diversification benefits. On top of their negative correlation with equities and low correlation with government bonds, choosing global rather than domestic inflation-linked bonds increases the diversification benefits.
- Looking beyond the domestic market opens the door to a larger and often more liquid market. The inflation-linked bond market keeps growing, but some individual markets still have liquidity problems. A global approach makes it easier to get around these obstacles.
Further reading: How interest rate rises affect ordinary people
Source: Morningstar
Featured image: Wikimedia Commons user Geisslr, Public domain, via Wikimedia Commons.
