Market Insight: Inflation-Linked Bonds | Mackenzie Investments

Market Insight: Inflation-Linked Bonds


Inflation – a significant risk for core-fixed income portfolios

One risk of investing in traditional or nominal bonds, which pay a fixed coupon and mature at par value, is that inflation can erode the purchasing power of the interest and principal over time. Inflation-linked bonds provide protection against this risk by linking the interest and principal to prevailing inflation rates during the bond's term.


Contrasting a nominal bond to an inflation-linked bond

  NOMINAL BOND INFLATION-LINKED BOND
Semi-annual payment Fixed payment – stated coupon Variable payment – the stated coupon rate is applied to the inflation adjusted principal value
Coupon amount Coupon is higher than for an inflation-linked bond because it is made up of a real yield plus an estimated inflation amount Coupon is lower because it pays a real yield plus (or minus) inflation experienced over the term of the bond
Principal amount at maturity

Fixed at par value

Inflation adjusted principal value. The principal at maturity can be higher than the par value but not lower due to the "deflation floor" set at par
Market price Variable Variable – compared to nominal long-term bonds of similar maturity, inflation-linked bonds are somewhat less volatile because they react more to changes in real yields than changes in interest rates

Nominal Bond and Inflation-Linked Bond Chart

What is real yield?

Real yield is the nominal bond yield minus the rate of inflation.

What does a nominal bond provide? A variable real yield but a constant payment.

What does an inflation-linked bond provide? A constant real yield but a variable payment.

How do inflation-linked bonds work?

Example:
20 year inflation-linked bond, par value $1,000, coupon 2.8% (1.4% semi-annual), annual CPI 4.5% (2.25% semi-annual).

First payment:

1. Calculate the inflation-adjusted principal: $1000 × 1.0225% = $1,022.50

2. Apply the coupon rate to the inflation-adjusted principal: $1,022.50 × 1.4% = $14.32

How to calculate YTM at the end of year one:

1. Use the actual interest payments and the inflation-adjusted principal value

($14.32 + $14.63)   =  2.8% YTM
($1,022.50 × 1.0225)

What would the inflation-adjusted principal, real principal value and last interest payment be if the inflation rate was 4.5% for 20 years?

1. Inflation-adjusted principal after 20 years: $2,435.19

2. Real principal value after 20 years: $1,000.00

3. Final interest payment ($2,435.19 x 1.4%): $34.09

How do inflation-linked bonds work?

Breakeven inflation rate = Yield on a fixed coupon (nominal) bond Yield on an inflation-linked bond

Why is the breakeven inflation rate important?

The breakeven rate estimates the rate of inflation needed for an investor to be indifferent between owning an inflation-linked bond and a nominal bond.

If the expected rate of inflation is higher than the breakeven inflation rate, it may be a good time for investors to consider an inflation-linked bond purchase.

If the expected rate of inflation is lower than the breakeven inflation rate, nominal bonds are likely the better option.

What is "real" yield?

Real Yield = Nominal bond yield – rate of inflation

How are "real yield" and the "breakeven inflation rate" related?

The "breakeven inflation rate" uses known yields to calculate an implied inflation rate while "real yield" is estimated using known nominal bond yields and a historic inflation rate (real time CPI estimates are not available).

A Closer Look

Below is a comparison of a US Treasury (or nominal bond) to a US inflation-linked bond. Both bonds were issued in the summer of 2009. The market price of each bond is tracked by the blue line; both bonds experienced price volatility over the nine years since their issue.

The orange line shows the inflation-adjusted principal of each and it highlights a key difference. The inflation-adjusted value of the nominal bond's principal has declined over the bond's lifetime demonstrating the loss of purchasing power even during a very benign inflation environment. Compare that to the increase in the inflation-adjusted principal of the inflation-linked bond which while rising in nominal terms, remains unchanged in real terms.

The third line (in grey) shown on the inflation-linked bond chart is its market value. The market value of the inflation-linked bond is calculated by multiplying the market price by the inflation-adjusted principal value. The market value of an inflation-linked bond is the settlement price for transactions after issue and before maturity. While also showing volatility, the market value of the inflationlinked bond is less volatile than both the market price of the nominal bond and that of the inflation-linked bond.

The interest paid on the nominal bond does not change in nominal terms but declines in real terms while the interest paid on the inflation-linked bond rises in nominal terms but is unchanged in real terms. Importantly, the nominal bond's stated coupon is higher than the inflation-linked bond's because its coupon is a combination of real yield plus compensation for the estimated impact of inflation over the bond's term. The inflation-linked bond's payment stream is a real yield plus the actual (but trailing) rate of inflation – which is headline CPI.

Graph
Source: Bloomberg from August 21, 2009 to July 20, 2018.

How and when to use inflation-linked bonds in a portfolio

Inflation-linked bonds are generally considered part of a core fixed income portfolio. Their credit quality is generally equal to government-issued nominal bonds with the same term. However, in contrast to nominal bonds which are negatively correlated to inflation, inflation-linked bonds may increase in value during periods of high or rising inflation. Like nominal bonds, inflation-linked bonds have duration risk. In fact, in Canada, the inflation-linked bond market is a long duration one as bonds are issued with terms of ten years or greater. Given these attributes, there are times when owning or building an inflation-linked bond exposure can be helpful in diversifying a core fixed income portfolio. The opposite is also true: sometimes owning traditional or nominal bonds will provide a better investment experience. The matrix below demonstrates how exposures to inflation-linked bonds might be adjusted based on the economic environment.

  GROWTH EXPECTATIONS
INFLATION EXPECTATIONS
  Low/falling High/rising
High/rising

Core Bond Holdings

  • Policy rates likely to remain steady
  • Expect ILB to outperform as principal and interest payments adjust higher with inflation

Core Bond Holdings

  • Policy rates increases are likely
  • Expect ILB to strongly outperform but the duration impact is likely negative for both ILB and nominal bonds
Low/falling

Core Bond Holdings

  • Policy rates could fall
  • Expect ILB to underperform in part due to their lower coupo

Core Bond Holdings

  • Policy rates likely to remain steady
  • Expect significant underperformance from ILB due to lower coupon; duration impact is likely negative for both ILB and nominal bonds

Inflation-linked bonds in action

The graph below the annual performance of inflation-linked bonds in Canada and the US. It also shows the annual performance of the FTSE Bond Universe to provide a simplistic relative performance perspective. Inflation-linked bond returns can be impacted by changes in real yield, inflation rates, economic outlook and to a lesser extent, liquidity concerns and relative value. In 2008, for example, inflation-linked bonds underperformed nominal bonds in large part because of liquidity concerns – but deflation worries also played a role. In 2011, the US Federal Open Market Committee announced its first QE program which would purchase $600 billion in bonds at a time when oil was over $100 a barrel. Inflation expectations rose and inflation-linked bonds did well. 2013 was the year of the infamous Taper Tantrum. After four years of strong performance, inflation-linked bonds (particularly in Canada) were expensive and less attractive relative to nominal bonds. Coupled with the threat of rising policy rates combined with low inflation pushed real yields higher and inflation-linked bond prices fell.

Graph
Source: Morningstar Direct, as of 2006 to 2017, and YTD 2018 as June 30

Contrasting Canadian and US inflation-linked bonds

  REAL RETURN BONDS (RRB) TREASURY INFLATION – PROTECTED
SECURITIES (TIPS)
Country of issuance Canada US
Measure of inflation Headline CPI (reported monthly
interpolated daily)
Headline CPI (reported monthly
interpolated daily)
Term to maturity 20-30 years
(more duration risk)/td>
5, 10 & 30 years
(more opportunity to determine
duration profile)
Market size and opportunity $77 billion $1.35 trillion

Getting Inflation-linked bond exposure through Mackenzie's actively managed fixed income offerings:

The Mackenzie Fixed Income Team will build and hold exposures to inflation-linked bonds such as RRBs and TIPS when they appear to be good relative value and the economic environment favourable. Funds that typically look for opportunities to build in inflation-linked exposures are Mackenzie's core and core plus fixed income funds including Mackenzie Strategic Bond Fund, Mackenzie Canadian Bond Fund and the global tactical suite of funds (Mackenzie Global Tactical Bond Fund, Mackenzie Global Tactical Investment Grade Bond Fund, Mackenzie USD Global Tactical Bond Fund). Inflation-linked bonds are also likely to be featured, when appropriate in certain of Mackenzie's actively managed fixed-income ETFs including Mackenzie Core Plus Global Fixed Income ETF (MGB) and Mackenzie Core Plus Canadian Fixed Income ETF (MKB).

Looking for a pure exposure?

If being an active decision-maker in allocating to inflation-linked bonds as part of an overall diversified fixed income portfolio is preferred, Mackenzie offers Mackenzie US TIPS Index ETF (CAD-Hedged) – ticker symbol QTIP. QTIP is a passively managed ETF that is almost exclusively invested in US inflation-linked bonds with terms ranging from 1 year to over 25 years. QTIP tracks a broad-based inflation-linked bond index provided by Frankfurt based Solactive. Invested in more than 37 distinct US TIPS, QTIP's duration is approximately 7.5 years, with a weighted average maturity of approximately 8.5 years.

 

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This document includes forward-looking information that is based on forecasts of future events as of June 30, 2018. Mackenzie Financial Corporation will not necessarily update the information to reflect changes after that date. Forward-looking statements are not guarantees of future performance and risks and uncertainties often cause actual results to differ materially from forward-looking information or expectations. Some of these risks are changes to or volatility in the economy, politics, securities markets, interest rates, currency exchange rates, business competition, capital markets, technology, laws, or when catastrophic events occur. Do not place undue reliance on forward-looking information. In addition, any statement about companies is not an endorsement or recommendation to buy or sell any security.