Delivering real bond returns

In the short to medium term inflation is likely be influenced by the shape of the pandemic recovery. Any positive vaccine news and further fiscal packages seem set to contribute to the economic recovery and thus inflation. At the same time the risk of another wave of infections prompting renewed containment measures, persistent high unemployment rates and trade tensions would cause disinflationary pressures. The likelihood of any of the latter factors occurring looks high. What might investors do to mitigate inflation risk?

Beware four inflation factors

Four factors have typically led to a sustainable increase in inflation: a supply shock (such as a rise in the oil price), economic surprise, substantial increase in money circulation or a strong currency devaluation.

While any of the above should be considered, for now the risk looks low. For example, the money supply surged by 23% this year in the US, with the supply partly absorbed by the US Federal Reserve’s (Fed) balance sheet and is therefore not fully inflationary. While a surge in debt levels can lead to inflation, in the last 50 years the correlation with inflation was negative not positive.

Overall a rise in prices over a longer period represents a risk for nominal assets and future purchasing power. It is certainly true that inflation-linked bonds (ILBs) can help to hedge against inflation risk. But understanding the dynamics and technicalities of the bonds is important when considering this strategy.

The case for inflation-linked bonds

The value of inflation-linked bonds is, as the name suggests, linked to inflation. In the US they are known as Treasury Inflation-Protected Securities (TIPS) while in the UK they are often referred to as linkers. The most established type of bonds (even in the UK now) are Canadian-style bonds which are explained in brief below.

First of all, ILBs are similar to conventional bonds as they carry a coupon, have a maturity (100) and offer a yield known as the real yield. And as with nominal debt, the bonds deal with a chicken-and-egg conundrum (what was first?): the price at the issue date and during the life of the security determines the real yield while equally the level of the real yield determines its price.

How does the inflation protection work?

Inflation-linked bonds are tied to a domestic inflation index: the consumer price index (CPI) in the US, while in the UK the reference index is the retail price index (RPI). Each of the indices had a starting point at 100 when the index was established and surges when prices increase and declines when prices fall in respective inflation baskets. In fact, any reported inflation rate is based on the change of the index level (for example, month on month or year on year). With Canadian-style bonds, the nominal value of a bond increases with the underlying index.

Given that various ILBs are issued at a different time, each one carries an individual index ratio which is set at one at launch and grows in line with the respective reference index, the CPI index in the US. Assuming that over a period of ten years inflation averages 2% a year, the index ratio would grow from 1 to 1.22. Instead of receiving 100, as would be the case for nominal bonds, the investor receives 100 x 1.22 (index ratio at maturity) or 122. A gain of 22% as a result of inflation.

The same principle applies when selling (or buying) a bond during its lifetime. An investor selling at 111.7 today receives 111.7 x 1.003 (index ratio today), equivalent to 112.06. The index ratio ensures that each investor is compensated for inflation during any given holding period. While the index ratio in line with the CPI index can decline in a deflationary environment during the holding period, the index ratio is floored at one.

Linking inflation, breakeven and real yield

Investors often assume that an inflation-linked bond pays a coupon linked to the inflation rate. However, this is not the case as the coupon is static. As described in the previous section, the inflation gain can only be crystalised at maturity or at the point of sale of the bond while the economic impact is the same. In the same example, the real yield of the bond is -1%. Assuming the inflation rate is 2% over one year (change of index) the realised yield in nominal terms would be 1%.

Breakeven inflation

In assessing the relative attractiveness of ILBs, investors often consider the so-called breakeven inflation rate. Given all else is equal, there is a choice between buying either an ILB at a real yield of -1% or a nominal bond of the same issuer and same maturity with a nominal yield of 0.7%.

With the nominal bond, the future return to maturity is known in advance (0.7% a year). In order to realise the same return over the holding period, the index ratio of the ILB must increase by 1.7% annually on average (the 10-year breakeven rate). Voila! If an investor decides between the nominal bond and the ILB and believes that inflation will average more than 1.7% over the holding period, then the latter should offer the better return, in this case, and vice versa.

Not the end of the story

The good news is that ILBs protect investors against inflation. No matter the magnitude of price hikes, the realised (purchased) real yield is unaffected by inflation. While inflation surprises or expectation changes by the market pose the biggest risk for nominal yields, it is not one for real yields.

That said, nominal yields as well as real alternatives can also rise due to a shift in the demand for, or supply of, bonds (such as shifts in amounts of Fed bond buying or treasury supply) or investor sentiment (for instance, if sentiment improves and bonds are sold as capital flows back to other assets).

ILB strategy and diversification

ILBs appeal as part of a diversified bond allocation given the additional inflation protection. However, longer-dated linkers seem more appropriate as a way of capturing any long-term shift in inflation, rather than trying to capture a full recovery of inflation with shorter-dated ILBs, given that the risk of a second wave or a slower-than-expected recovery is still high. Overall, a well-diversified portfolio seems to be the most efficient way to mitigate inflation risk.

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