Are inflation-linked bonds a hedge against rising inflation?
Inflation-linked bonds (ILBs) as an asset class are now around 13 years old in South Africa and have delivered significant returns of over 13% per annum for that period. This time frame has been characterised by sharply rising and falling inflation and in
The total return from ILBs can be broken up into two components: an inflation-indexed income accrual and a capital gain or loss due to the move in the real yield at which the bond is trading in the market.
1. The income accrual – this component of return is derived from the relevant monthly inflation uplift as realised by the headline CPI month-on-month index (with a three-month lag), plus the monthly accrual from the yield of the bond. This first component of return is fairly stable and predictable and the fundamental backdrop that will drive the accrual is the level of yield and inflation. When inflation and/or real yields are high, this part of the total return will be enhanced and vice versa. Very simply, if inflation is 6% for the year and the level of real yield is 2%, all else being equal; the nominal return for ILBs will be 8%.
That’s easy enough. You want to own these bonds when yields are high and inflation is rising/high. However, there is another component to total return of these instruments that is a little more complicated and, more often than not, the dominant driver of performance.
2. Capital gain – this component of return is derived from the change in value of the capital invested in the ILB due to a change in the level of real rates in the market. Real rates are not static, they move up and down for any number of reasons, i.e. they are driven by the expected monetary policy cycle, a change in inflation expectations and the relative demand/supply imbalance at any particular time. Just like a nominal bond, ILBs pay a fixed coupon rate (although it’s a real rate, not a nominal one). This coupon rate remains fixed at the original level when the bond was issued for the entire maturity of the bond. Thus, when real yields fall below the coupon rate of the ILB, the present value of the future cash flows from the ILB increases and vice versa. A new investor would need to pay a premium for an ILB that pays a real coupon of 3% if the current level of real rates at the time of investing is 2%. Likewise, there will be a discount for an investor who buys an ILB that pays a real coupon of 3% if current real rates in the market are at 4%. The movement of real rates in the market thus generates either capital gains (when real rates are falling) or capital losses (when real rates are rising). The extent of these capital moves are determined by the term-to-maturity and the level of the real coupon of the bond. The longer the term to maturity of the ILB and the lower the coupon, the more sensitive the capital value of the bond is to moves in the level of real rate. This is the concept of modified duration that investors may be more used to in nominal bond markets.
So, from the above we can see that the total return of an ILB over a specific investment horizon = real yield coupon accrual + inflation + the capital gain/loss from the move in real yields.
For passive (buy and hold until maturity) investors, the analysis is fairly easy. You will earn the first component of return as highlighted above: the yield and inflation accrual over the maturity of the investment. For active investors/asset allocators, the second component of return, i.e. capital volatility, becomes very important. The level of real yield you invest at, and the subsequent magnitude of the move in yields post your investment, will dominate the performance of the instrument. As ILBs tend to have fairly high modified duration (long maturity and low coupon), they are very sensitive to a move in real yields. It is this capital volatility that will drive performance in volatile markets and investors need to consider this when evaluating ex-post or ex-ante expectations for ILBs.
Does this help us contextualise the performance that ILBs have delivered since their inception and, more relevantly, the phenomenal performance over the last couple of years (followed by the current bout of underperformance)?
Broadly speaking, the graph below shows a strong correlation between the move in inflation and the performance of the ILB index. However, one can see that this breaks down in certain periods, i.e. in 2001 where, despite falling inflation, ILBs continued to perform well, and in 2006 to 2007 where, despite rising inflation, ILBs began to underperform. It is during these periods that investors basing their asset allocation decision on expected inflation would have potentially been surprised by the performance of ILBs (positively in 2001, negatively in 2006 to 2007). In addition, there are examples where, even though ILB performance is moving in the expected direction as correlated with inflation, the performance under shoots or over shoots. A case in point is the recent period 2010 to 2012 where, despite fairly benignly rising inflation, ILBs delivered around 18% per annum.
Source: Momentum Asset Management (June 2013)
From this it should be evident that the investor’s view on the move in real yields is crucial in formulating a total return expectation for ILBs. More often than not, rising inflation is not initially followed by a rise in real yields and ILBs perform well. Ultimately, however, policy will have to tighten to restore inflation stability and it is during this policy tightening that, despite high inflation, ILBs will underperform due to the capital losses created by rising real yields. Conversely, when inflation is falling, ILBs tend to underperform initially as there is no immediate response from policy, i.e. real yields drift higher and, only when authorities ease policy, do real rates begin to fall and the appropriate capital gains come through for ILBs. This is a counter-intuitive period in the cycle where ILBs can perform well despite low inflation.
The ILB reality is thus a complex one. Over entire cycles, the underlying inflation trend should drive performance, but one needs to mindful of the leads and lags during the cycle where real yields adjust in response to monetary policy actions/expectations. These changes in real yields cause capital volatility and tend to dominate returns while they are occurring.
This makes why ILBs have performed so well in general over the last two years very clear. We have had rising inflation and plummeting real yields: a perfect storm for ILBs. The graph below shows the move in real yields in blue and the relative performance of ILBs against cash (rolling one year) in red. The size of the move down in real yields to all-time lows has generated capital gains of huge magnitude. The purple bars, which show the monthly inflation accruals and are generally expected to drive the performance of ILBs, are almost coincidental in this context.
Source: I-NET (May 2013)
Based on this, the risk to ILBs is therefore a rise in real yields from the historically low level reached in April. Global markets are much more focused on a tightening of macro policy by the US Federal Reserve (FED) given the FED’s recent statements. The initial reaction to the rising real yields in the US has been a dramatic rise in local ILB yields, which, given the points discussed above, has caused pronounced underperformance through capital depreciation, despite rising inflation locally. Cutting through all the noise, a further rise in real yields should be fairly contained, in our view, as the US economy does not appear in need of significant policy tightening and our local authorities still seem comfortable in not responding to a rising domestic inflation threat by hiking rates. This should keep local real rates relatively contained, perhaps resulting in inflation dominating the contribution to performance rather than capital volatility (which has dominated for some time now).
