Many markets for inflation-linked bonds (also referred to as “linkers”) were born out of investor demand for both the safety of government debt relative to comparatively more credit risky borrowers, as well as real income that is protected from the risk of higher inflation. Although the income potential has been gradually squeezed from these assets as real interest rates have fallen, inflation protection remains a potent feature of linkers, and one that has seen considerable variation in demand in recent years. The fallout from lower energy prices over the two years, combined with hawkish Fed rhetoric amid a mediocre recovery, have served to dampen the inflation outlook in multiple economies, though the prices of energy commodities are gradually finding a new equilibrium. Combined with protectionist political agendas beginning to gain traction, and the basis of monetary policy frameworks around the globe being questioned, new opportunities within inflation-linked bond markets are emerging.
We briefly explore the mechanics and considerations of investing in inflation-linked bond markets, as well as our approach to utilizing these instruments within our fixed income portfolios.
Markets and mechanics for inflation-linked bonds
Inflation-linked bonds have their interest and principal cash flows explicitly tied to changes in inflation rates, as determined from a reference consumer price index (CPI). The notional principal of the bond will rise as the CPI level increases and falls as the index declines, with the future coupon payments determined based on this inflation adjusted principal. For linkers in some markets, the notional amount itself does not fall below the starting level established when the bond was first issued, meaning there is an embedded floor within these bonds that prevents falling inflation from eroding their original principal. While this structure implies that the cash flows and nominal value of such bonds are inherently uncertain, as the evolution of future inflation is unknown in advance, they will retain the same purchasing power as they had when the bond was first issued.
The economic differences between nominal and inflation-linked bonds are accompanied by structural differences between these two markets. Many nominal developed government bond markets draw participation from a broad investor base, and feature regular issuance across the term structure. Inflation-linked bond markets for the same issuers however, tend to have a narrower investor base, with liability hedging end-users often constituting a significant portion of demand for the product and taking down substantial shares of the supply. Canadian Real Return Bonds and Index-linked UK Gilts are both examples of markets occupied primarily by these types of investors, while US TIPS exhibit comparatively more diversified sources of interest, ranging from private asset managers to large official sector investors such as reserve managers and sovereign wealth funds.
The return characteristics of inflation-linked bonds share a common thread with their conventional nominal counterparts in that they are both exposed to interest rate risk. The longer the duration of the bond in question, the greater the price volatility encountered for a given shift in the applicable yield curve. A key difference in these exposures is that linkers respond to changes in real interest rates, while conventional bonds adjust to movements in nominal interest rates. The differences between these two term structures, measured on similar maturity nominal and inflation-linked bonds, are referred to as breakeven inflation rates (or “breakevens” for short). Understanding the nature of breakevens is crucial to positioning effectively in inflation-linked bond markets, as the volatility here can result in a significant divergence between nominal return and real return assets.
Breakeven inflation rate movements incorporate the balance of risks around a combination of longer-run and shorter-term inflation dynamics. As alluded to earlier, reported inflation readings bear significant importance for determining the carry returns for linker positions on an outright and breakevens basis, while surveyed inflation expectations provide guidelines for breakevens levels over longer time horizons. Since linkers’ cash flows track movements in broad headline CPI measures, it is generally price swings in the most volatile components that drive changes in linker cash flows and thus breakevens, particularly for shorter maturity issues. Such components can include prices of key commodities (notably energy and food), and exchange rate movements in small open economies like Canada and the UK. As some of these prices tend to be positively correlated to swings in broader risk sentiment across asset markets, breakevens also vary partly due to changes in shorter-term market volatility. In addition, many central banks implement inflation targeting regimes, which seek to limit substantial increases in inflation, while providing support for falling inflation. Given the variety of forces at play in influencing inflation breakevens, a focused approach is a necessity for those looking to engage in inflation-linked bond investments.
Inflation-linked bond investments at Signature
Many fixed income asset managers aim to provide returns principally through the credit spectrum and via duration management. At Signature, we utilize a diverse array of levers in our efforts to add value, with inflation-linked bonds playing one such role.
Our approach to investing in the inflation-linked bond domain at Signature is tactical in nature, utilizing these instruments as a portfolio diversifier relative to nominal bonds. Some of the opportunities we pursue include:
- Obtaining exposure to rising inflation pressures during periods where the upside risks to inflation dynamics appear underappreciated in market pricing.
- Enhancing the carry earned within the portfolio throughout periods where inflation tends to run at an above average pace.
Beyond these tactical considerations, there is a role for linkers to play in portfolio allocations as well. Despite the subdued inflation backdrop many advanced economies are faced with presently, guarding our portfolios against a prospective shift toward a more inflationary environment may become a more pressing priority. The more immediate risks that feature prominently in our minds are the emerging tones of trade protectionism within the political arena, and potential revisions to central bank policy frameworks allowing for much greater tolerance of higher inflation. We at Signature will continue to make use of this important lever to manage our fixed income portfolios through such challenges to the current bond market status quo.