In this letter, Norges Bank offers advice on the role that inflation-linked bonds should play in the benchmark index for the Government Pension Fund Global. The letter builds on the assessments made in our letter of 6 July 2010 on the development of the investment strategy for the fund, and our letter of 18 March 2011 on the benchmark index for nominal bonds.
Inflation-linked bonds currently form part of the strategic benchmark index’s GDP-weighted sub-index for government bonds, based on their relative market weight. The share of inflation-linked bonds in the benchmark index is very small. We consider two issues in this letter: whether inflation-linked bonds should be part of the strategic benchmark index for bonds, and whether the market for inflation-linked bonds has sufficient breadth and depth to provide the basis for a separate strategic allocation.
Our recommendation is that inflation-linked bonds are now removed from the benchmark index for the fund’s bond investments. This change would clarify the strategic role that government bonds play in the benchmark index and make the index simpler, more transparent and more readily verifiable. This change could be made rapidly, as the volume of inflation-linked bonds in the benchmark index is so small that this would not impact appreciably on its risk and return characteristics.
Inflation-linked and nominal bonds
When we invest in nominal bonds, the coupons and principal we receive are fixed in nominal terms. Thus an investment in a nominal bond secures a nominal interest rate over the life of the bond. Unexpected increases in inflation will reduce the real value of the investment. Investors will therefore normally require compensation for bearing this inflation risk. The size of this risk premium varies over time but can be considerable in periods of great uncertainty about the inflation outlook.
Inflation-linked bonds differ from nominal bonds in that coupons and principal are adjusted in line with movements in an inflation index. Thus an investment in an inflation-linked bond secures a known real return over the life of the bond. An inflation-linked bond will therefore be the safest investment option for a long-term investor looking to limit the uncertainty associated with the future real value of his capital.
If inflation turns out to be higher than discounted in market prices at the time of investment, investments in inflation-linked bonds will help reduce the loss of value in the bond portfolio. Investors requiring this insurance accept that the expected return on inflation-linked bonds will normally be lower than on nominal bonds.
Inflation-linked and nominal bonds have different and, in some situations, contradictory characteristics in periods of variation in real interest rates and inflation risk, and so play different strategic roles in a portfolio. Index suppliers therefore have separate products for inflation-linked bonds. The theoretical and empirical differences between inflation-linked and nominal bonds are discussed in a separate note..]
If bonds with different strategic roles are kept separate in the benchmark index, the index will be simpler, more transparent and more readily verifiable as a strategic basis for the fund’s bond investments.
Norges Bank is of the opinion that inflation-linked bonds should be removed from the strategic benchmark index for bonds.
The market for inflation-linked bonds
The market capitalisation of inflation-linked bonds is less than 10 percent of the market for government bonds and is dominated by the UK and the US. Linkers issued by authorities in these two countries make up almost 60 percent of the world market.
The geographical distribution of the government bond sub-index in the fund’s new benchmark index is based on different countries’ economic output. The authorities in a number of countries with a considerable economic output, including China, India and Russia, have not issued inflation-linked bonds. The same is the case in many smaller countries, and large developed markets in the benchmark index such as Japan and Germany have only small and relatively illiquid markets for inflation-linked bonds (see appendix).
In some markets, tax and regulatory conditions may affect the structural demand for, and therefore the supply of, inflation-linked bonds. The fund’s government bond sub-index passively reflects these local market conditions. There is no reason to believe that this passive adaptation of the benchmark index to local market structure is right for the fund.
In a situation where there is a growing probability of deflation, inflation-linked bonds could have markedly different characteristics in different countries, as the underlying rules vary. Linkers are not identical across markets and are therefore difficult to view as a global asset class. Structural aspects of the market for inflation-linked bonds are discussed in a separate note.
The combination of a long investment horizon, no short-term liquidity needs and a patient owner generally make the fund well-suited to bearing different types of systematic risk. The inflation risk in nominal bonds may be a type of risk that the fund is particularly well-suited to bearing.
Considerable weight was attached to the high level of liquidity in the market for nominal government bonds when constructing the benchmark index for bonds. Experience from the financial crisis in 2008 showed, however, that in periods of financial instability we cannot count on the same level of liquidity in the market for inflation-linked bonds. Tradability in these situations is lower, and we therefore bear a higher liquidity risk than for investments in nominal government bonds. Nevertheless, it is not a given that we can expect to systematically reap a liquidity premium through a strategic allocation to this market.
A broad portfolio of real assets could give the fund a broader representation of the underlying growth in the economies in which it is invested. This could contribute to greater diversification and reduce the risk associated with the objective of maximum international purchasing power. The overall composition of the fund’s investments should expose the fund to real growth in the global economy. Inflation-linked bonds provide insurance against inflation, but do not necessarily reflect this growth in the economy.
Our assessment is that the market for inflation-linked bonds is not sufficiently broad, deep and uniform to be capable of diversifying the fund’s risk in the event of a sudden and unexpected rise in inflation. Inflation-linked bonds should not therefore be given a separate strategic allocation.
Linkers may, however, have a role in the operational management of the fund when it is possible to secure an attractive real return and inflation expectations are considered moderate.
Norges Bank is of the opinion that the fund should not have a separate strategic allocation to inflation-linked bonds.
Norges Bank’s recommendations
Our advice on inflation-linked bonds in the strategic benchmark index can be summed up as follows:
- Inflation-linked bonds should be removed from the strategic benchmark index for bonds
- A separate strategic allocation to inflation-linked bonds should not be introduced
Øystein Olsen Yngve Slyngstad