Top stocks to invest in – Global Inflation-Linked Bonds: A Primer

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The CFA Institute Fixed-Income Management Conference is an annual event focused on global debt markets, fixed-income sectors, security selection, and portfolio construction. The Fixed-Income Management 2017 Conference will bring together researchers, analysts, portfolio managers, and top strategists in Boston, Massachusetts, on 12–13 October.

So what are inflation-linked bonds? They are most typically debts issued by sovereign nations whose nominal interest rate is adjusted, either up or down, by an inflation measure.

Despite the obvious allure of this kind of debt — it eliminates a risk: inflation, duh! — there are not many issuers worldwide. Total global issuance is $3 trillion. The United States, with $1.2 trillion, and the United Kingdom, at about $800 billion, are the principal movers, though there is growing issuance in France, Italy, Spain, Germany, and Brazil, among other markets.

Despite correcting for a critical risk faced by fixed-income investors, these instruments typically trade with a lot of volatility. This is because a large portion of the market is composed of a very long duration issue from the United Kingdom with a 50-year maturity. Therefore, much of the volatility in the global market comes from the United Kingdom, though many investors don’t realize it.

Another risk familiar to fixed-income investors is illiquidity. Since the global market for inflation-linked securities is just $3 trillion, investors are not as liquid as they are in more traditional sovereign issues. That said, the US Treasury Inflation-Protected Securities (TIPS) market continues to grow its trading volumes.

Inflation-linked bonds function just like “normal” bonds in which the actuarial yield is the same as the nominal yield. In other words, the standard yield calculations are identical, except that the yield is a real yield and not a nominal yield. This, of course, is because the yields are adjusted for inflation.

While it may seem that straightforward credit analysis is all that is needed to assess inflation-linked securities, that is not true. Why? There is considerable trading price volatility generated around announcements of the latest inflation measures. Each inflation-linked security adjusts its yield based on an inflation measure outlined in the indenture.

For example, if you own TIPS, then you can expect volatility in the price of your bonds when the Consumer Price Index (CPI) figures are announced. So having an independent calculation for your inflation-linked bond’s inflation measure becomes essential for maximizing returns adjusted for risks.

In the United States, CPI has several odd characteristics. First, 42.5% of the calculation is made up of changes in housing prices. Thus, mispricing of real estate results in a severe mis-estimate of TIPS’ value. Also, CPI adjusts for energy prices, which are notoriously volatile. This also means that inflation-linked securities are definitely not good places to “park cash” since their return is unlikely to be as stable as more traditional money market securities.

Additionally, many inflation measures adjust for seasonality. So given the uptick in spending around the end-of-the-year holidays, you can expect more volatility in the pricing of these instruments as inflation measures compensate for this spending. In the United States, this leads to a somewhat predictable pattern of TIPS breakevens rising early in the year before declining again toward the end of the year.

The calculation for the breakeven rate is not solely about inflation expectations. In addition, investors must add to the par value a premium for eliminating purchasing power risk and subtract a relative liquidity premium.

For shorter term breakevens, the price of energy is by far the most important consideration. Recent trends in headline and core inflation components (adjusted for volatile components); costs of carry; and any preference for liquidity on the part of investors can also have an effect.

For longer term breakevens, the most important consideration is what central banks are doing. Medium-term inflation and wage trends; inflation volatility; supply of inflation-linked securities and of course investors’ liquidity preferences are also factors.

Beyond hedging for outsized inflation — the obvious use of inflation-linked debt — the par floor in these securities is a deflation hedge. This is because at maturity you either get the higher of par and your yield or par. Consequently, if yields go negative — as they are in many sovereign debt markets — then you receive back par, and not a shrunken principal. Obviously, in this case you have to hold to maturity. But there is optionality in the pricing of inflation-linked debt on both the upside and the downside.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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