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Inflation-linked Bonds explained

Inflation, defined as the sustained increase in the general price level of goods and services in an economy over a period of time, is one of the most detrimental forces facing investors as it erodes real returns of investments. Any long-term investment strategy should consider provisions against inflation risk.

Many types of assets and investment strategies offer inflation risk protection to investors. For example, the inflation-fighting nature of some commodity assets have routinely been documented. Additionally, some equity sectors such as import and export stocks are also sensitive to an expected price pressure (e.g. energy). However, the most common building block of an inflation-beating strategy is likely to come in the shape of inflation-linked government bonds. Many of the governments of developed countries issue inflation-linked bonds as a way to hedge their inflation linked income (tax income) and provide low-cost financing.

Basic features of inflation linked bonds

An index linked bond (aka “linkers”) is typically issued by the government of a sovereign nation. Its cash flow is similar to a nominal government bond with periodic coupon payment and principal repayment at maturity, but coupon and principal payment will grow with inflation specified by a given referenced index. Therefore, most linkers provide a guarantee of at least 100% of capital repayment at maturity (except UK, Canada and Japan) which protects investors against a prolonged period of deflation. The table below illustrates some of the most common inflation bonds:

Inflation-linked bonds

Linkers are often compared against the fixed rate government bonds (where coupons and principal do not grow with inflation) of similar maturity, where their yields are evaluated. The yield on a fixed rate government bond is typically called the nominal yield, which comprises of the real yield of the bond investment together with the effect of inflation, whilst the return on linkers investment is simply just its real yield as the bond return is specified as a rate in excess of inflation.

This difference between nominal bonds and inflation linked bonds therefore raise an important concept known as break-even inflation rate, which refers to the difference between the yield on a nominal fixed-rate bond and the real yield on linker of similar maturity and credit quality. If inflation averages more than the break-even rate, the inflation-linked investment will outperform the fixed-rate bonds. Conversely, if inflation averages below the break-even, the fixed-rates will outperform the linkers. For instance, the current breakeven rate for the 10 Year government bonds for the US, UK, Germany, Italy and Japan are 1.60%, 2.3%, 0.97%, 0.76% and 0.39% respectively, which reflects the different long term inflation expectation in each market.

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Risk of inflation linked product

The risk associated with inflation linked bond investments includes mainly sovereign credit risk and interest rate risk. Sovereign credit risk typically refers to the risk of a government becoming unwilling or unable to meet its loan obligations. Typically speaking, a linker’s cash flow is heavily skewed towards its maturity date as a greater proportion of the coupon payments are embedded in a later part of its term. It is therefore more sensitive to the sovereign credit risk compared to the corresponding nominal bonds. However, sovereign risk is considered to be low for most developed country governments.

Arguably a more significant type of risk for investing inflation linked bonds would be interest rate risk, which is the sensitivity of bond yield to any changes in market interest rate measured by a term called duration. The higher the duration of a bond, the larger changes in bond’s yield in response to changes in market interest rate would be.  Additionally, the interest rate risk for a linker can be evaluated by reviewing the yield equivalent fixed rate bond and beta, which measures the yield sensitivity of a linker to a change in the equivalent nominal yield. The commonly accepted assumption for beta value of linkers across different markets is 0.5.

Investing in inflation linked bond via ETF instruments

Compared to holding inflation linked government bonds, exchange-traded funds (ETFs) of linkers often allow investors to efficiently construct an inflation-shielding strategy within their portfolios. In most cases it will also be more cost-effective than using more traditional investment vehicles or directly investing in inflation-linked bonds.

Developed market inflation linked ETFs (despite of the small size of its ETF universe compared to that of other key asset classes) provide full coverage of the whole maturity spectrum of the inflation-linked market and improves the liquidity of the underlying market and therefore makes it easier for investors to access it. Inflation-linked bonds are typically biased to long-dated maturities. As a result, the linker ETFs tend to have high duration metrics. Therefore, an inflation hedging strategy may hold a mix of asset classes to account for different time horizons in addition to linker ETFs.

The annual management charge for most inflation-linked bond ETFs is between 0.20% to 0.25%, measured in terms of assets under management. This cost compares positively to those actively managed and traditional index-tracking funds. According to Morningstar, an investment research firm, the average annual management fee for an active fund varies between 0.75% and 1.5%, whilst the average management fee for a passive index-tracker would be around 0.40%. As cost is the only certainty when investing, one can argue that using inflation-linked ETFs as one of the building blocks for portfolio construction is compelling.

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