Inflation Linked Bonds

Careful selection is needed to identify value

By Hamlin Lovell, NordicInvestor

My previous article “Preparing for Higher Inflation” outlined several asset classes (index linked bonds, cash, floating rate debt, corporate debt, equities, commodities, commodity equities, real estate, and infrastructures). This article drills a little deeper into index linked bonds. Both short term interest rates, and yields on longer term government debt, are below inflation in most developed countries. Are inflation-linked government bonds a solution?

Return drivers

Whereas a nominal government bond repays its par value of 100 at maturity, for a linker, the principal rises with reference to a price index (such as the UK Retail Prices Index (RPI), the European Harmonised Index of Consumer Prices (HICP) or the US Consumer Price Index (CPI)).  Although different EU countries’ inflation rates differ, within the Eurozone currency area they tend to use the HICP. Outside the Eurozone, local inflation indices may be used. Sweden for instance uses the Sweden CPI.

Additionally, while the coupon income is fixed as a percentage of the principal, the nominal coupon gets lifted up by the rising tide of the principal.

Under a deflation scenario, most linkers guarantee that the principal is floored at the issue price, known as the “deflation floor”. So, at some point of zero or negative inflation, linkers can temporarily converge with nominal bonds – but retain some optionality should inflation rise. (Japan is an exception to the rule as its bonds have not always contained a deflation floor).

However, linkers – and particularly longer-term bonds-  still have significant interest rate sensitivity, which can in some cases be greater than their inflation sensitivity. Therefore, some investors and funds looking to emphasise near term inflation protection prefer to focus on shorter maturities. Additionally, with the US yield curve very flat, there is not that much yield pickup to be had from longer maturities.

Breakevens 

If investors buy a bond when it is first issued, and hold it to maturity (as some pension funds may do) then inflation and interest rates over the life of the bond are the key return drivers.

If investors buy a bond later on, its valuation may have risen to discount higher (or fallen to discount lower), inflation. That changes the breakeven arithmetic of how high inflation needs to be for the linker to outperform a nominal bond. The breakeven inflation rate is the nominal bond yield, minus the real yield on a linker of the same maturity.

Longer dated UK index-linked gilts are perceived to be expensive, with very low – or even negative – real yields. The culprit is thought to be captive demand from UK pension funds that are basically forced buyers. UK defined benefit pension funds promise to increase pensions in line with inflation (whereas many schemes in continental Europe are not bound to–and those in the Netherlands even have some latitude to reduce pensions for the current generation of retirees in order to maintain commitments to future generations). The valuation of longer dated UK gilts is so high that they are expected to generate negative real returns, which would appear to be precisely the opposite of the objective of linkers!

US TIPS are generally seen as better value, but US break-evens have risen in 2018, reflecting higher inflation expectations. The US 10 Year break-even rate just touched 2.2%, the highest since 2014, as shown below. Still, for anyone expecting a serious resurgence of inflation, as seen in the late 1960s or 1970s, this is not a high hurdle.

In emerging markets, Brazilian linkers have offered much higher yields and returns, for those who feel comfortable with the risks.

Liquidity and 2008 

In 2008, breakevens in the US briefly touched zero. This was a function of TIPS selling off during the financial crisis. The swoon in TIPS has been ascribed to them being less liquid than nominal Government bonds, and therefore vulnerable to the liquidity driven crash of late 2008. Leveraged investors likely became forced sellers in 2008, as lines of credit were withdrawn, and investors redeemed from funds.

Products and fees

In the UK linkers market, at least 15 managers tracked by Morningstar are running active inflation linked bond funds: Aberdeen Standard, Allianz, AXA, Baillie Gifford, BlackRock, Dimensional, HSBC, Insight, Janus Henderson, Legg Mason, M&G, Royal London, Schroders, SEI and St James Place.

There are also global inflation linked bond fund, such as one run by Fidelity, which can allocate to linkers issued by corporates, as well as those from Governments.

There are index trackers (tracking an index of inflation linked bonds) from Legal and General and Scottish Widows. There is also an ETFs from iShares.

Fees for actively managed bond funds are lower than for equity funds, so (any) fee savings from an index tracker or ETF tend to be much smaller. The iShares product has ongoing charges of 0.16%, but Allianz, for instance, offered an early bird share class charging only 0.20% for the first GBP 205 million of a new active fund.  The Legal and General Inflation Linked Bond Fund has an OCF of 0.27%, which is almost the same as the actively managed Royal London Index Linked Fund, with has an OCF of only 0.31% (for share class M). Institutional mandates are thought to offer lower fees than these retail share classes.

The only hedge fund manager I know of that specialises in inflation linked debt is Linden Grove. Various global macro, and fixed income arbitrage managers may have some exposure to the asset class.

The market – Governments 

The great majority of the debt is issued by Governments. The global inflation linked bond market is worth just over USD 3 trillion, with over USD 1 trillion of US paper, and most of the rest in other developed countries. The UK Government is one of the largest non-US issuers, with GBP 400 billion outstanding. Italy is the biggest issuer in the Eurozone. France and Germany and are other important Eurozone issuers.

Elsewhere in the OECD, Japan, South Korea, Australia and Canada all issue inflation linked bonds.

In emerging markets, Brazil and South Africa are amongst the largest issuers, with Mexico, Turkey, Argentina, and Thailand other issuers.

The market – Corporates

M&G offers a UK Inflation Linked Corporate Bond fund, with an average credit rating of A-, which is somewhat lower than the AA rating of UK government linker funds. In fact, only about 10.6% of the assets are in corporate inflation linked bonds. The largest allocation at 49.6% is “synthetic inflation linked”, which suggests that nominal bonds are being combined with some form of swap to create an inflation linked return stream. This may be due to the scarcity of inflation linked corporate debt.