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Risks and Rewards of Inflation-Linked Bonds

DISCUSSION NOTE 10 - 17 August 2012

Inflation-linked bonds are fixed-income securities whose principal and coupons are linked to price indices. They are designed to eliminate the risk of unexpected inflation to the holders of the bonds. In this discussion note, we compare the risks and rewards of inflation-linked bonds with those of nominal fixed-income securities. We also evaluate the role of index-linked bonds in diversified portfolios.

Main findings

  • Inflation-linked bonds have benefits for issuers and investors alike. Issuers may be able to lower their cost of financing, demonstrate commitment to low inflation, extract information for monetary policy purposes, and contribute to the completeness of financial markets.
  • For investors, inflation-linked bonds without credit risk are the safest long-term asset, allowing them to reduce long-horizon risk and hedge liabilities, but also take short-term positions on inflation expectations.
  • While nominal bonds can serve the strategic purpose of hedging the volatility of the equity risk premium in the short-to-medium term, the strategic function of inflation-linked bonds, when held to maturity, is to hedge long-run inflation risk. The strategic role of inflation-linked bonds therefore differs from that of nominal bonds.
  • The yield spread between nominal and real bonds – the so-called break-even inflation rate – is influenced by expected inflation, but can also incorporate an inflation risk premium and a liquidity premium.
  • In the intermediate term, the relative return of linkers versus nominal bonds depends on the evolution of break-even inflation rates. Real bonds outperform when break-even inflation rises, which is usually caused by higher expected inflation and/or inflation uncertainty. When break-even inflation falls, for example in a disinflationary scenario, nominal bonds do better than linkers.
  • The real yield of linkers reflects the expected path of real short rates, which in turn depends on the outlook for economic growth and inflation. It is also influenced by structural factors such as liability hedging demand from pension funds and insurance companies. The real return might therefore differ from underlying economic growth.
  • The appeal of developed-country inflation-indexed bonds to long-term investors currently comes at a high cost in terms of expected returns, as real yields have declined over the last decade and are around zero for an index of developed-country linkers. Emerging-market linkers offer higher real yields.
      

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