Inflation Linked Bonds – Why They Don’t Work (In All Situations)

The first inflation linked bond (or linker) was launched in 1780 by the Massachusetts Bay Company. Although inflation was a much less understood or easily measured concept back then, the need for inflation protection has been acutely felt since the inception of financial markets.

Inflation linked bonds (ILBs) only came into investor consciousness properly however post their introduction in the 1980s by the UK DMO and in 1997 by the US Treasury. This resulted in the most liquid inflation linked bond market of today the US$500bn (notional) US TIPs market. TIPs stand for Treasury Inflation Protected Securities.

To contextualise the issues of ILBs we must appreciate that their pricing dynamics are essentially the same as nominal bonds. That is to say, the market determined price of a nominal bond is the collection of its cash flows (fixed coupon x principal) and principal repayment, all discounted to the present value via relevant discount rates.

Following from this, the sole differentiating technical factor between nominal and ILBs is that the inflation linked bond receives an adjustment to coupons and principal value (paid at maturity) based on an inflation tracking index (typically CPI).

Because of this, ILBs (to some degree) suffer or benefit from the same interest rate sensitivity risk (also known as duration) that nominal bonds are exposed to. In-fact, the mathematical duration risk of ILBs is  higher than nominal bonds due to ILB fixed coupons being set much lower during inception (to account for the fact that real cash flows will be inflated by the adjustments to the principal value).

Despite this we do not hold any disagreement with the fact that ILBs in general tend to preserve capital better than nominal bonds during a rising rate environment. The reason for superior capital preservation can be clearly inferred by the fact that rising interest rates are accompanied (or caused by) strong economic activity and thus typically inflation.

In this case the nominal bonds suffer value erosion both from inflationary effects and discounting effects, whilst ILBs suffer only duration risk.

There are reasons however to call into question the reliability of ILBs.

The academic approach to the relationship between nominal and inflation bonds has over the years been boiled down to an approach of treating real (inflation linked) rates as beta weighted nominal rate.

The beta of real rates to nominal rates is determined by the covariance between real and nominal rates divided by the overall all variance of nominal rates (as seen below).

To simplify, one can say that ILBs behave similarly in duration risk terms to nominals when nominal yields change due to non-inflationary reasons and they are insulated from duration risk when nominal yields are rising for inflationary reasons.

This is an intuitive relationship and can be understood in an even more simple way. ILBs require inflation to be ‘realised’ in terms of CPI prints to percolate through into the index that determines the inflation linked capital value of the bond.

Although bonds require daily price discovery (which is achieved via interpolation of the most recent CPI measures) the actual inflation expectations become blurred as they are projected further into the future.

This means that longer tenor ILBs are not as responsive to a single or a small collection of CPI prints, as duration risk (and the response of longer term inflation expectations) can overpower the accumulative effects of the revalued principal.

The above can actually be observed empirically (courtesy of Vanguard) in that since 2002, the correlation of US TIPs with actual inflation is actually inversely related to the maturity of the bond in question.

The other key factor that determines ILBs value compared to nominal bonds is the break-even inflation rate (BEI).

It is a much debated question of whether inflation expectations are the tail that wags the ILB dog or vice versa. As there is no widely agreed method or model for estimating long-term inflation expectations, macro observers take market-based expectations of future inflation as the best available guess. These market-based inflation expectations are the very same input used to determine ILBs relative value to nominals, creating a type of feedback loop.

What is clear however is that the possibility for capital losses on ILBs is very dependent on the break-even inflation expectations at the point of purchase versus subsequent realised inflation.

In aggregate, we summarise our position on ILBs as follows. Although we acknowledge they are relatively superior to nominal bonds in terms of capital preservation (to varying degrees), they are still susceptible to capital losses on absolute terms. Running a globally unconstrained mandate, we are running no duration risk in bonds (at current interest rate levels) and are expressing inflation risk through a conventional yield steepener.

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By |2018-03-27T09:22:33+00:00March 27th, 2018|Asset Allocation, Cerno Capital Posts, General Investment, Other Posts|

About the Author:

Ion is an investment analyst and supports the portfolio team on implementation and consistency on both individual portfolio and the strategy levels. His investment work is across all the firm’s strategies with a specific focus on the macro component and non-equity classes. Ion joined the firm after completing internships at Credit Suisse and Bank of America Merrill Lynch in London. Previous to that he had completed internships at Cerno Capital and other asset-management institutions. Ion holds a BSc (Hons) in Statistics & Finance from the London School of Economics.