Inflation-linked bonds during periods of inflation: how best to use them?

With inflation at its highest level in decades, what returns should investors expect from inflation-linked bonds – and are they the best form of inflation protection?

09/02/2023
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Authors

Lesley-Ann Morgan
Global Head of Pensions and Retirement
Ugo Montrucchio
Multi-Asset Fund Manager
Ben Popatlal
Multi-Asset Strategist

Consumer price growth hit a 40-year high during 2022, making inflation one of the biggest problems for central banks, governments and investors. While in recent months there may be signs of inflation starting to moderate, many investors are still looking for the right type of exposure to guard against future price increases.

Inflation-linked bonds (ILBs) are an obvious place to look. But how much protection do these instruments offer?

There are three questions to answer:

1. Do the returns on inflation-linked bonds correlate with inflation?

2. If they do, how well do they protect against it?

3. Finally, are there other assets in a diversified universe that may offer better protection against inflation?

In this paper we have conducted our analysis using US Treasury Inflation Protected Securities (TIPS), but the same principles apply to UK Index-linked Gilts and other inflation-linked bonds. TIPS were first auctioned in January 1997. The UK was one of the earliest developed economies to issue index-linked bonds for institutional investors, with the first issue being in 1981.

What are Inflation-linked bonds?

Inflation-linked bonds, as the name suggests, are issues whose capital and interest payments (the coupon) are linked to a recognised measure of inflation. In the US, for example, this is the Consumer Price Index. They are designed to protect investors from the risk of increase in prices by adjusting their principal amounts based on broad price changes in order to maintain their real value.

Unlike nominal bonds, the interest payments and principal value at maturity on inflation-linked bonds are adjusted to reflect the changes in a chosen Consumer Price Index (CPI basket). In general terms, given that the cash flows of these securities vary according to the prevailing level of inflation, if consumer prices rise, investors will receive a larger compensation at their expiry date.

  1. How do inflation-linked bonds correlate with inflation?

In theory, TIPS should fully compensate an investor for a rise in inflation. In other words, the return on these assets should be highly correlated with realised inflation, preserving the real value1 of capital.

But in practice – as shown in Figure 1, below – this may not always be the case.

To understand why, step back for a moment and consider the alternative risks confronted by investors who have chosen nominal bonds versus inflation linked securities.

In simple terms, a nominal bond investor is compensated for two key risks borne during the investment horizon: the erosion of purchasing power (the nominal value the investment) posed by a subsequent increase in inflation; and the fluctuation in the real interest rate component (the yield on the nominal bond).

By contrast, an investor in an inflation-linked bond does not face market risk in respect of realised inflation over the investment horizon. They do confront the same risk as the nominal bond investor for the real yield component. If the loss accrued by higher real interest rates outweighs the cash flows offered by the inflation index, the total investment return will be negative (and therefore lower than the rate of inflation).

Crucially, this is true even if the inflation experienced during the life of the investment proves to be higher than expected.

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Source: Schroders, Refinitiv, Dec 2022.

2. So, how well do they protect against inflation?

It is helpful to compare this investment to a similar allocation in a similar nominal bond. On a like-for-like basis, an inflation-linked bond ought to outperform its nominal equivalent if and only if the realised inflation during the life of the investment exceeds the expected inflation that is discounted in today’s market prices.

A worked example: nominal bonds vs inflation-linked bonds

At present2, the most frequently traded two-year USD inflation-linked bond is priced to yield 0.5% between now and its maturity; the equivalent maturity nominal bond yields 3.25%3. On this basis, the two-year inflation breakeven (the rate of inflation embedded in today’s nominal bond prices) is approximately 2.75% . So, if you buy TIPS, you get 0.5% in real terms; if you buy the nominal bond, your real return is 3.25% minus whatever realised inflation is over two years.

So if realised inflation is greater than the breakeven (expected) inflation rate, then the real return of a nominal bond will be less than the return of its inflation-linked equivalent, as shown in Figure 2.

If the opposite occurs, and realised inflation is less than expected, then the nominal bond return is superior, as seen in Figure 3.

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Source: Schroders, Bloomberg, December 2022. Note: yield data comes from US 2 year note and US 2 year inflation-linked note.

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Source: Schroders, Bloomberg, December 2022. Note: yield data comes from US 2 year note and US 2 year inflation-linked note.

Confronted with a choice between the two instruments, an investor should favour the inflation-linked asset if her expectation of realised, annualised inflation over the two years (between now and 2024) exceeds 2.75% (today’s estimate of future inflation). If she thinks realised inflation will be lower, she should prefer to allocate to nominal bonds. This is a simple but often missed principle for determining which asset class to favour.

Investors need to consider whether the market (breakeven rate) is under-pricing inflation. It may not be worth buying TIPS if the breakeven rate is already pricing in expectations of very high inflation: it could be better to buy the nominal bonds, on the basis that the nominal bond yield is sufficiently high to take the inflation hit.

As an example, Figure 4 shows the difference between realised and expected inflation over one year. If the difference between these two variables is positive, an investor would have been better off by allocating to inflation linked securities (and vice versa).

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Source: Schroders, Refinitiv, December 2022.

Of course predicting future inflation and seeing how that differs from the market’s expectations is a complex exercise. Many institutional investors have their own independent inflation forecasting models, drawing upon the expertise of in-house and external economists.

In the absence of such resource, investors can observe central bank actions and statements. If a central bank seeks to reduce inflation by curbing monetary stimulus in the economy, it is logical to expect that the cost of money ought to increase to induce a slowdown in economic activity and demand. In this simplified scenario, we may expect real yields to rise, realised inflation to fall, and TIPS to underperform nominals.

By contrast if a central bank continues to provide stimulus by keeping monetary conditions easy and allowing inflation to accelerate, inflation-linked bonds would be expected to outperform their nominal equivalent. Observing the central bank’s attitude towards an increase in local prices represents another example of the old adage “don’t fight the Fed”. It provides a helpful yardstick for investors forming a view on the trajectory of inflation.

3. How do TIPS compare to other inflation protection assets?

Inflation-linked bonds should offer more promising inflation-hedging potential than other asset classes as their interest payments and principal amounts are adjusted, based on broad price changes.

However, as demonstrated above, when held for periods shorter than their time to maturity, returns can be volatile relative to inflation. This is because the price impact of movements in real yields can sometimes outweigh their inflation-linked income.

Because of this, TIPS may not always be the best inflation hedge in a multi-asset portfolio. (We are not talking here about investors matching their liability payments and duration to specific bonds. We mean an asset class that broadly provides returns that increase with inflation, or provide above inflation returns.)

Beating inflation: how have inflation-linked bonds performed in the past?

Figure 5 shows the percentage of rolling 12-month periods since TIPS’ first issuance in 1997 during which different asset classes posted positive real returns. The colours represent how consistently different asset classes achieved this from red (poor), through amber (average), to green (good).

Compared to other asset classes, TIPS tended to outperform inflation the majority of the time, but they are not the best inflation hedge when inflation is rising, and tend to be better when inflation is falling. For example, in a low and rising inflation regime, TIPS delivered positive real returns 72% of the time. By comparison equities outperformed inflation 88% of the time (more than any other asset class and in spite of their poor inflation sensitivity). However, this analysis has limitations in that the timeframe does not include periods of extreme inflation as were experienced in 2022.

Index-linked bonds

Source: Schroders, Refinitiv. Data from March 1997 to December 2022. Notes: based on monthly rolling annual returns relative to the contemporaneous rate of inflation, where frequency <50% (red), 50%<X<67% (amber), >67% (green). Low/high inflation is defined as the average inflation rate over the preceding 12-month period. Rising/falling is defined as the change in the inflation rate over 12 months. Rate of occurrence refers to number of rolling 12-month periods in each inflation regime.

As seen in Figure 5, multiple asset classes can outperform inflation in different environments. Figure 6 shows how the average real return can vary.

For example, although gold has been less consistent in terms of outperformance than some of its peers in times of high and rising inflation, the magnitude of the real return received was far superior. On average, over a 12-month period, gold returned 21% above inflation during such periods. So when gold outperformed, it did so exceptionally strongly. By contrast, TIPS posted positive real returns that were a third of the level of gold’s outperformance.

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Source: Schroders, Refinitiv. Data from March 1973 to December 2022, except TIPS from March 1997.

Summary

1. TIPS provide returns above inflation in most inflation environments, although there are other asset classes that have offered better real returns. For example, in a high and rising inflation regime, when inflation protection is particularly important, commodities tend to outperform TIPS. In a high and falling inflation environment, nominal bonds and TIPS may offer better protection.

2. The choice of nominal or inflation-linked bonds depends on an investor’s judgement about whether inflation over the holding period is likely to exceed market expectations of inflation. Inflation-linked bonds outperform their nominal equivalents in real terms when realised inflation exceeds expected inflation for the period. It is also worth noting that inflation-linked bonds have longer duration than nominal bonds for the same maturity – so in aggregate they are more sensitive to movements in real yields. Additionally, the liquidity of inflation-linked bonds tends to be poorer and transaction costs higher.

3. Predicting the type of inflation regime we are likely to be in and forecasting inflation are both difficult. Therefore diversifying across different types of assets that are likely to provide returns above inflation could be the most appropriate strategy in an inflation environment that has not been experienced for over four decades, at least until a slowdown environment becomes more evident, when fixed income typically performs well relative to other asset classes.

1Data from Bloomberg as of December 2022.

2Real Value intended as the Nominal value of invested capital taking away the realised inflation accrued over time.

3The breakeven rate may be subject to slightly different estimates owing to methodology being used and the interpolation chosen for different points on the curve. For the purpose of this paper, these are technical points that are not influencing our general conclusions.

Authors

Lesley-Ann Morgan
Global Head of Pensions and Retirement
Ugo Montrucchio
Multi-Asset Fund Manager
Ben Popatlal
Multi-Asset Strategist

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