“Inflation-linked bonds (ILB) offer investors a fixed income instrument between floating- and fixed-rate bonds that protects against inflation.”
LONDON, 5 May 2003 — The purpose of this article is to provide investors with basic information and some interesting insights into the world of inflation-linked bonds. The topic is a rather complex one, and for the sake of better understanding, we simplify and stress on the main characteristics only.
Inflation-linked bonds (ILB) offer investors a fixed income instrument between floating- and fixed-rate bonds that protects against inflation. These securities insure investors a “real” rate of return. In other words, they protect investors’ purchasing power because the coupons and principal payments are adjusted to compensate for changes in inflation.
The issuers of such bonds assume that inflation expectations are too high compared to what the outcome will really be. The issue is cheap in terms of borrowing costs because investors buy an ”insurance against a loss of purchasing power” and are therefore willing to accept lower yields. Issuers are usually governments, public authorities, international bodies, but banks and corporate as well.
Buyers assume that the government is not able to implement an anti inflationary policy and wish to protect their savings against inflation.
The best way to understand how an investment in ILB works is to compare it with the purchase of a conventional bond. Imagine yourself investing $1000 in a conventional bond with a fix 5 percent coupon with a maturity of 5 years. For each of the following 5 years you face coupon payments of $50 and at maturity you are given back the invested principal for the amount of $1000. The yield on your investment is 5 percent.
Let us assume a constant annual inflation rate of 1.5 percent and invest the same $1000 in an ILB bond with a fix 4 percent coupon with a maturity of 5 years. The first coupon payment at the end of the first year will be based on the inflation-adjusted principal ($1000 — 1.5 percent=$1015) and amounts to $40.60 ($1015 — 4 percent). The following adjustments take place for the following years as well. The yield on this investment is 5.6 percent. Overall, if inflation is assumed to be constant over the period, the resulting yield is approximately the coupon of 4 percent plus the inflation rate of 1.5 percent. Note that, in case of deflation, the inflation-adjusted principal could be below the initial par amount. In this case the coupon payments would still be based on the inflation-adjusted principal.
At maturity however, the redemption of the principal will never be lower than the original par amount ($1000). Comparing the duration of an ILB and a “normal” bond needs adjustments because the first reacts to shifts in real rates, whereas the latter to a shifts in normal rates.
As real rates are less volatile than normal rates (usually a beta coefficient between 0.4 and 0.6 is used), the duration of ILB is usually shorter.
Although we all know that past performance is no guarantee for future performance, it is worth looking at past returns. In the US, ILB were the best performing asset class in 2002, according to Lehman Brothers striking 16.57 percent (“normal” treasuries 11.6 percent). Since the beginning of 2003 up to March, 17 they are up 4.2 percent (vs. 0.8 percent). In the past six years, 10 year ILB have posted average annual returns of 7.4 percent. Looking at Europe, linkers returned 13.11 percent in 2002, according to Barclays and in January 2003 the return was 2.51 percent. Will this trend continue?
The decision to buy ILB depends on the current environment and on expectations about inflation.
A good reference to look at in this context is the breakeven inflation, which represents the level of inflation expected over the maturity to make equivalent a purchase of “normal” bonds and ILB. It is basically the difference between the nominal and the real yield.
In Europe the 10-year breakeven inflation rate is actually at 2.02 percent, whereas in the US it stands at 1.86 percent, despite present inflation being around 2.5 percent. In other words, the market expects inflation to decrease.
Investors not sharing this view and expecting an inflation rate above 1.86 percent should buy US ILB. Note that the BEP is a moving benchmark. Therefore, investors should watch it closely.
Remember that investors buy ILB also as an insurance; the BEP is therefore not the only thing to look at. From a fiscal policy side, there is pressure on governments to stimulate demand, as the economy does not seem to grow enough. War financing and reconstruction costs contribute as well to an expansionary fiscal policy. From the monetary policy side, it seems that the stance is to maintain an accommodative policy.
There is a strong will from the authorities (governments as well as central banks) to fight deflation fear at any costs, meaning at cost of inflation.
The authorities are so committed in not let deflation even happen, that being that expansive will avoid deflation, but probably create inflation. In this environment ILB should perform better than normal treasuries, although a repetition of the marvelous performances, backed by strongly decreasing interest rates as in 2002, is less likely.
Investors expecting:
Stagflation (no growth with inflation)
Nominal yields to stay the same but inflation to rise Nominal yields to increase more than real yields or
real yields to fall more than nominal yields, as it was the case in 2002, should go for ILB. The investment is also ideal for life insurers and pension funds, whose liabilities are linked to inflation.
In tax matters it is extremely problematic to generalize. However, examining a sample of treasuries and public authorities ILB issues, it appears that ILB (regardless of the issuer) are not subject to withholding tax, but are subject to income tax on the coupon (although the percent can differ, depending on the issuer).
Every issuer (individual or corporate) is subject to income tax, according to tax legislation at his place of domicile.
(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information.)
