With Inflation-Linked Bonds
By Dan Lomelino, Kim Gillett and Marko Komarynsky
in Emphasis 2010/3, we outlined the risk of elevated inflation to p&C insurers. in this
follow-up, we examine the viability of various inflation-hedging instruments.
Inflation-Linked Bonds Linkers Around the World
When discussing inflation hedging, the first U.S. TIPS use the Canadian model, with a deflation
instrument that usually comes to mind is inflation- floor. The U.K. was the last of the G7 nations to
linked bonds (or linkers). According to Barclays adopt the Canadian model, in 2007. Most developed
Capital, 13 of the 20 largest countries in terms of countries now also include a deflation floor in their
GDP have an inflation-linked market. The largest inflation-linked bonds.
market for linkers in the world is the Treasury
The U.K. has a long history of issuing linkers, dating
Inflation-Protected Securities (TIPS) market, issued
back to 1981, and they currently make up 33% of the
by the U.S. Treasury. Since its inception in 1997, the
U.K. gilt market, according to Barclays Capital, while
TIPS market has grown to approximately $600 billion
U.S. TIPS are less than 10% of the U.S. Treasury
in outstanding debt, or roughly 40% of the global
market. U.K. gilt linkers use the Retail Price Index
(RPI) as their inflation index. However, since 2003,
A U.S. TIPS coupon is a fixed rate determined at the Bank of England has used the U.K. CPI as its
auction. The coupon is applied to an inflation- inflation target. Recently, the U.K. government
adjusted principal dependent on the nonseasonally announced plans to require that U.K. CPI be used
adjusted Consumer Price Index for All Urban for future private pension liabilities. As of yet, there
Consumers (CPI-U) with a three-month lag. The are no plans by the U.K. Debt Management Office to
inflation-adjusted principal is then paid out at maturity. issue gilt linkers indexed to U.K. CPI. Given the
Unlike the nominal Treasury, the dollar amount of the expected increased demand by pension funds for
coupon payment is unknown at the time of purchase the CPI linkers, it’s logical to expect there might be a
because the principal amount is adjusted monthly change at some point in the future. Until that time,
based on realized inflation. At maturity, the owner of many believe the gilt linker market will suffer from
the TIPS coupon receives the principal back from the supply-and-demand imbalances.
government based on the cumulative total inflation
Sovereign linkers in the Euro-zone are generally
that occurred over the life of the bond.
issued with the reference index of the Harmonized
It’s important to note that the principal amount can Index of Consumer Prices excluding tobacco (HICPx).
increase or decrease depending on inflation or In Europe, France was the first to issue inflation-linked
deflation. However, the principal paid at maturity will bonds, and France and Italy are the largest issuers in
not fall below par value. This principal protection the European market. Germany was relatively late in
that U.S. TIPS provide can also be thought of as a issuing linkers, and the German market has been
deflation put or deflation floor. slow to develop. Greece has also issued linkers, but
its market is less liquid, and its linkers were taken
“The world’s largest market for inflation-linked out of the Barclays indices at the end of 2009.
Because of Japan’s recent history of deflation,
bonds is the Tips market, issued by the Japanese linkers have not been as popular among
U.s. Treasury.” domestic investors as in the U.S., U.K. and Europe.
The Japanese suspended issuance of inflation-linked
bonds in the fall of 2008 during the financial crisis.
In 2009, the Ministry of Finance embarked on a
Figure 1. Historical U.S. TIPS breakevens
Breakeven inflation rate (%)
–2% U.S. asset manager
–3% Towers Watson,
June Dec. June Dec. June Dec. June Dec. June Dec. June Dec. June Dec. June Dec. Chicago
2003 2003 2004 2004 2005 2005 2006 2006 2007 2007 2008 2008 2009 2009 2010 2010
Five-Year Seven-Year 10-Year 20-Year 30-Year
Source: U.S. Treasury
buyback program that retired 40% of the original expects inflation to be higher than the breakeven rate
issuance, and it recently announced that there would prefer TIPS over nominal bonds, and vice versa.
would be no new issuance of inflation-linked bonds
If you sell out of your position before maturity, there
in fiscal year 2011.
are many factors beyond the market’s inflation/
Australia also suspended its inflation-linked bond disinflation view that can drive the breakeven rate.
program in 2003, but unlike Japan, it did so because For instance, the relative value of nominal Treasuries Kim Gillett
of budget surpluses. In 2009, the Australian is considered to be adversely affected by an increase fixed-income
government reintroduced its Treasury Indexed Bond in the inflation risk premium or the risk associated investments and
program and appears to be committed to its success. with increased inflation volatility. Conversely, nominal U.S. asset manager
Treasuries are seen as having a liquidity premium Towers Watson,
The long history of Latin America linkers was
that makes them more attractive; they are preferred Chicago
precipitated by the devaluations and hyperinflation that
by the market during flight-to-quality episodes.
some of that region’s countries have experienced.
The region’s overall success weathering the recent The liquidity premium was an especially prevalent
global financial crisis has given Latin American issue in late 2008 and early 2009 in the U.S. During
governments more freedom in terms of what type of the crisis, investors across the globe had a strong
debt they can issue. Some in the region, such as preference for on-the-run nominal Treasuries
Argentina, have stopped issuing linkers, and others, because they were seen as the ultimate safe-harbor
such as Mexico, have linker markets dominated by investment in the world’s reserve currency. The
domestic investors. Brazil, on the other hand, is the market consensus is that this flight to safety was
fourth-largest issuer of inflation-linked bonds in the the largest factor in TIPS underperformance relative
world. Latin America has probably the least to nominal Treasuries in 2008. However, the massive Marko Komarynsky
homogeneous market. Latin American countries do flight to quality that so negatively impacted TIPS Specializes in
not entirely follow the Canadian model, and each breakeven spreads were compounded by 2008’s investments and
country has unique aspects to its inflation index. economic reality: heightened deflation fears resulting leads U.S. asset
from the shock the credit crisis had on the economy. manager research.
Breakevens and Risk Premiums Overall, 2008 showed that TIPS breakevens can be Chicago
The yield to maturity on a TIPS is considered a real driven by both technical factors, such as liquidity, and
yield — the yield earned over the life of the bond by fundamental factors, such as deflationary fears.
over and above the level of inflation that investors Using the relative share of each factor (technical
can lock in today. The difference in yield between the and fundamental) to compare the performance of
nominal 10-year Treasury and the 10-year TIPS is TIPS against nominals can be notoriously difficult
called an inflation breakeven rate. An investor who and highly dependent on assumptions.
Emphasis 2011/1 | 17
Figure 2. Historical secular trends in nominal U.S. yields and inflation
Inflation-linked bonds are relatively straightforward
instruments that provide a direct hedge against
inflation. If a liability is based on the same reference
2% inflation index, the effectiveness of a hedge is
0% limited only by any timing mismatch between the
liability and the bond portfolio. If there is a serious
timing mismatch, the hedge is exposed to real
1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010
interest rate risk as well as fluctuations in the
CPI-U 10-Year U.S. Treasury
liquidity and inflation-risk premiums.
Source: Bureau of Labor Statistics, U.S. Federal Reserve Currently, real yields in many countries still remain
historically low. Even if rates do normalize, Towers
The inflation-risk premium is also very difficult to
Watson’s long-term expectation is a 10-year real rate
measure precisely, but it is an important economic
of only 2% in the U.S. Given this low rate of return,
concept that has been the subject of numerous
some might choose to look at other potential
empirical economic studies. Studies that have
inflation-hedging instruments. Figure 3 shows some
measured inflation-risk premium over a long period
of the positives and negatives of popularly
of time in the U.S. and U.K. show that the inflation-
mentioned inflation hedges.
risk premium can vary considerably. More recent
studies in the U.S., U.K. and Euro-zone that used As Figure 3 illustrates, while commodities and
data from inflation-linked bond markets estimate equities do have their advantages, they are
“inflation-linked bonds are that the inflation-risk premium has been smaller and fundamentally incomplete hedges. For instance, a
relatively straightforward relatively more stable. future increase in the CPI could be the result of
instruments that provide higher medical costs because of demographic shifts.
The notion that the inflation-risk premium is smaller
Equities are also mentioned predominantly as an
a direct hedge against and more stable might be the result of a belief that the
inflation hedge, but in a stagflation scenario, it is
inflation.” major central banks have gotten better at fighting
unlikely that many equity sectors will perform well.
inflation. The best example of this is probably the
Some equity sectors, such as financials, will most
U.S. Federal Reserve. After a long period of
likely underperform under any inflation scenario.
stagflation, the U.S. started to experience relatively
Other sectors, such as industrials or technology,
benign inflation in the early 1980s. The move to a
might do well under some inflation scenarios, but
lower level of inflation corresponded with a decrease
not necessarily under every inflation scenario.
in both nominal and real yields (Figure 2).
There are economic arguments for using commodities,
It is also believed the inflation-risk premium has
equities or real estate as an inflation hedge. But
decreased. If the inflation-risk premium has, in fact,
these assets are more risky and more volatile than
come down as a result of improved inflation-fighting
inflation-linked bonds, with greater upside potential
performance by central banks, the implication is that
and downside risk. Ultimately, if the primary goal is
inflation-risk premium could rise if the central banks
to hedge inflation, inflation-linked bonds should
started to lose some of their credibility. That is to
provide a greater level of protection because a linker
say, if the Fed is currently in the early stages of an
is the only nonderivative security that has an explicit
easy-money policy that is sowing the seeds of future
link with inflation. That should imply that linkers offer
increased inflation, not only would TIPS do well
a larger measure of protection against inflation over
from increased realized inflation, they would also
a greater number of economic scenarios.
outperform most other assets due to an increase in
the inflation-risk premium.
Figure 3. A look at popular inflation hedges
Instrument Positives Negatives
Commodities • High historical correlation to CPI • Incomplete hedge
• No sovereign debt risk • Hard to implement. Which commodities? How to invest?
Equities • Hedge attained by ownership in real assets • Hedge unlikely to work in stagflation scenario similar to 1970s
• Exposure to equity market appreciation • Equity sectors will not react to various inflation drivers in same way
Real Estate • Hedge attained by ownership in real assets • Direct real estate investments have investability and liquidity issues
• Makes up large part of many inflation indices • Bubbles in U.S. and elsewhere raise validity concerns
Inflation-Linked Bonds • Complete hedge for life of bond • Sovereign debt risk, usually results in locking in of minimal real return
• Regulatory and accounting benefits • If timing mismatch, then face rate risk and changes in risk premuims
Inflation Derivatives • Ability to build highly customized hedges • Historically expensive with counterparty risk
• Complicated to implement with accounting implications
On the opposite end of the spectrum from Ultimately, while inflation-linked bonds do have
commodities and equities is the highly customized positive and negative aspects, there is no single
approach to inflation hedging achieved with inflation inflation hedge that will work for every investor in
derivatives. An inflation swap is one example of an every situation. Companies interested in pursuing
inflation derivative and is very similar to the better- an inflation-hedging program would do well to work
known interest rate swaps. For instance, a client with a knowledgeable consultant.
who is worried about an increase in inflation might
For those seriously considering a linkers hedging
pay a predetermined fixed rate and receive the CPI
strategy, a major stumbling block could be the
inflation rate over the life of the contract. Someone
current low interest rate environment in many
who is worried about disinflation or deflation might
countries. However, if the main concern is to hedge
take the other side of that trade. Other types of
inflation, timing the market in an effort to wait for
inflation derivatives can include inflation caps and
rates to normalize is not without its own set of risks.
floors, and real rate swaps.
First, it is possible that higher realized inflation
Derivatives are subject to counterparty risk, would be accompanied by lower real rates. This type
regulatory and accounting concerns that limit their of stagflation scenario could occur in the U.S., for
effectiveness for many insurance clients. In addition, instance, if there is a dollar crisis that pushes
recent academic research by Matthias Fleckenstein, nominal yields up, increases inflation and results in
Francis A. Longstaff and Hanno Lustig has shown lower real economic growth.
that TIPS have historically been underpriced relative
If inflation does increase, a more likely scenario
to a synthetic TIPS portfolio of nominal Treasuries
would be that real rates normalize and move higher
and inflation swaps. While the highly customized and
in Europe and the U.S. as a result of a continued and
tailored solutions that inflation derivatives provide
strengthening recovery. But it is never a good idea
might be of interest to some, inflation derivatives
to buy insurance after the fire has already started.
have historically been a relatively expensive hedge with
If inflation starts to become an issue, linkers could
many practical issues that limit their effectiveness.
outperform many other asset classes as more
market participants seek the inflation insurance this
Conclusion sector provides. In the scenario where realized
From an implementation standpoint, inflation-linked inflation increases and real rates move higher, the
bonds are superior to other assets from a risk-based wisdom of waiting will be highly dependent on the
capital perspective. Inflation derivatives do allow for company portfolio’s current allocation.
a more customized solution relative to inflation-
For comments or questions, call or e-mail
linked bonds, but even for those property & casualty
Dan Lomelino at +1 312 525 2232,
insurers with derivative capabilities, the adverse
accounting treatment of derivatives versus linkers The authors would like
Kim Gillett at +1 312 525 2363,
will make them an unlikely option for many. For an to thank steve Lowe and
insurance company, inflation-linked bonds provide
Marko Komarynsky at +1 312 525 2362, Tom mcintyre for their
the most complete inflation hedge in most economic
firstname.lastname@example.org. help with and contributions
conditions. From a practical standpoint, they are
also much easier to implement. to this article.
Emphasis 2011/1 | 19