This is the second part in a 4-part series on inflation-linked bonds.
We saw in the last post, which went through an introduction to inflation-linked bonds, that they’re government-backed bonds whose value rises in line with RPI.
They also tend to be priced by the market in such as way that the real returns from owning inflation-linked bonds should be the same as the real returns from nominal bonds.
So if the real returns from linkers are likely to be similar to nominal bonds, then what’s the point in owning them?
This brings us to the second part in the 4-part series, on why we should own inflation-linked bonds.
The advantages of inflation-linked bonds
There are four reasons why an investor might want to own inflation-linked bonds:
- For short-term unexpected inflation protection
- To fund their spending
- For their asymmetric return payoff
- As a diversifier
1. Short-term unexpected inflation protection
This is often touted as the main benefit of owning inflation-linked bonds – their ability to outperform nominals when there’s short-term unexpected inflation.
Let’s split ‘short-term unexpected inflation’ in two – we’ll take a quick look at short-term vs long-term inflation, then a look at unexpected vs expected inflation.
Over the long term, equities are extremely likely to protect investors against inflation. This is because:
- As the costs of goods and services increase, many companies are eventually able to pass those input cost increases on to consumers in the form of higher prices. This protects the companies (and therefore the share prices) from inflation.
- They’re higher risk. Equities have the highest chance out of any asset class of beating inflation by the largest amount in the long run, because they’re riskier than the alternatives (bonds, cash, commodities etc).
So stocks are great inflation hedges over the long run.
But over the short-term, it’s possible to have inflation surprises which an investor may want protection from, but which equities are too volatile to provide reliable protection from. As a result, inflation-linked bonds — particularly short-term linkers, which minimize their exposure to interest rates — can help hedge short-term volatility from changes in inflation, while equities can hedge the longer-term inflation risk.
So far, so straightforward.
But it’s generally the second half of the ‘short-term unexpected’ bit which can cause confusion. Inflation-linked bonds only provide outperformance against nominals when the inflation is unexpected.
We’ve seen that expected inflation is built in to the yield of a regular bond. If inflation equals the breakeven rate, then it won’t make any difference whether you buy and inflation-linked or a nominal bond.
It’s very easy to think “inflation is going up, I should buy inflation-linked bonds”. But this misses the point. If inflation-linked bonds are already pricing in that inflation, then you won’t receive any benefit over nominals from buying linkers.
Where inflation-linked bonds do shine is when there’s unexpected inflation. If actual inflation is higher than the market expects (i.e. higher than the breakeven inflation rate), then inflation-linked bonds will outperform nominal bonds.
So let’s have a look at the evidence behind inflation-linked bonds’ ability to protect investors against the combination of short-term unexpected inflation.
Here’s a great paper by Vanguard, titled “Commodities and short-term TIPS: how each combats unexpected inflation”. It’s got loads of great information in there about the performance of TIPS, so it’s worth taking a bit of time to have a look at it.
(NB: as a reminder, TIPS stands for Treasury Inflation-Protected Securities – it’s the US equivalent of UK index linked gilts).
The purpose of the paper is to compare the inflation hedging characteristics of commodities vs inflation-linked bonds. I’ve got a whole other series on commodities coming up (after the much-requested series on crypto), which will pick out the relevant commodities sections of the paper. For now, we’ll focus on the TIPS sections.
The first interesting graph is this one:
Here we can see a few things:
- Cash does very well at hedging against short-term expected inflation. This makes sense, as expected inflation is usually combatted by higher interest rates, which feeds through to higher rates paid on cash.
- TIPS, on the other hand, do a mediocre job at protecting against expected inflation. Where they really shine is their ability to combat unexpected inflation. Short-term TIPS has the highest correlation of all asset classes, alongside commodities, at protecting against unexpected inflation.
- It’s also interesting to see the difference between short-term TIPS and long-term TIPS. Long-term TIPS have roughly the same correlation to expected vs unexpected inflation, but short-term TIPS do much, much better than long-term TIPS at hedging unexpected inflation.
- Traditional bonds don’t do particularly well against expected inflation, but do terribly when there’s unexpected inflation. The difference in correlations between short-term TIPS and nominal bonds during periods of unexpected inflation is pretty stark.
- What may come as a surprise is the limited connection between unexpected inflation and asset classes with reputations as good inflation hedges – gold offers limited help, and REITs even less.
That chart does a good job at showing correlations of the asset classes against inflation, but the paper also looks at the beta of each asset class versus inflation. For example, if an asset has a high beta relative to unexpected inflation (i.e. if it goes up a lot when unexpected inflation goes up only a little), then you can afford to own less of it in your portfolio, leaving room for other asset classes.
The chart below maps the correlation of each asset class against its beta relative to unexpected inflation:
A few thoughts:
- The two commodity indices (S&P GSCI and BCOM) have significantly higher beta than those of other asset classes, along with relatively high correlation to unexpected inflation.
- Short-term TIPS have an even higher correlation (as we saw in the last chart) but come with a lower beta – i.e. they don’t move as much as commodities do when there’s high unexpected inflation.
- Long-term TIPS have the same drawback of short-term TIPS (lower beta) and also come with lower correlation to unexpected inflation. That’s not a great combination.
Vanguard conclude that for the highest stability, short-term TIPS are a good choice, but they offer less portfolio coverage. Commodities can protect more of the portfolio, although the connection with inflation isn’t quite as strong.
For those who are numerically minded and know their Z-scores from their P-values, the table below shows the betas for each asset class and their significance level:
Three of them show a significant relationship with unexpected inflation: the two commodities indexes and short-term TIPS. US bonds are nearly significant, but have a negative beta (as we saw in the first graph), while longer term TIPS are borderline positive. The table also puts into perspective just how much higher the beta is for commodities than for short-term TIPS.
But correlations and beta are only part of the story. It’s also important for an investment to show good persistence, or consistency, in its relationship with the objective. The chart below shows how persistent each asset classes beta is:
The chart shows:
- TIPS show a stable beta persistence to inflation, as they should. If relationship stability is highly valued, they are a solid choice. The beta for short-term TIPS is flatter, indicating strong persistence.
- Commodities: We see a tight connection between the S&P GSCI and the BCOM (which started in 1991). While earlier results showed high and generally positive correlation to unexpected inflation over time, these observations show significant volatility. Commodities’ high beta can offer coverage for the portfolio, but investors should be aware that the degree may vary over the short-term.
The final chart from the paper worth looking at considers the cost of hedging against unexpected inflation. Commodities and TIPS may offer the ability to counter unexpected inflation, but what does it cost the investor to buy this inflation protection?
The chart below shows the long return history of several assets:
Commodities’ long-term returns are not much different than cash, which makes intuitive sense. Improving technology and productivity gains constantly erode their prices, substitution and innovation can limit scarcity gains, and the cost of storage also has an impact. Over time, returns do not keep up with those of the long-term asset choices:
Annoyingly they don’t include the long-term returns of short-term TIPS in there, but I’d hazard a guess that they’d be similar to the Treasury bills return (i.e. similar to commodities). So both forms of short-term unexpected inflation come at the cost of longer term returns. Although I’d argue this I what we’d expect – I’d personally want to take my inflation protection from the ‘safe’ part of my portfolio (i.e. bonds). So it doesn’t make much sense to compare the returns of my hedge against equities, as that’s an entirely different section of my portfolio. A better comparison would be the long-term returns of short-term inflation-linked bonds against their nominal counterparts, as realistically this is the area that we’d be taking the allocation from.
The Vanguard paper’s overall conclusions are:
- Over long horizons, equities have outperformed inflation, which may be the ultimate protection against inflation. But for shorter-term offsets, commodities and short-term TIPS may be the best alternatives.
- Short-term TIPS are a stable and persistent choice. However, their modest beta means a large position must be taken to achieve significant inflation coverage. Commodities are well-correlated to unexpected inflation and have sufficient beta to provide a higher degree of inflation coverage but are much more volatile. As there is no ideal choice, investors must base their decision on their preferences and risk tolerance.
Evidence from Meketa Investment Group also confirms Vanguard’s findings that short-term inflation-linked bonds provide better protection against unexpectedly high inflation that longer-dated ones. The table below shows how TIPS with different levels of duration would have performed during the highest and lowest annual inflation periods since 1971:
But there are three other reasons investors may choose to hold them.
2. To fund their spending
You might very well be asking – why do I care about short-term unexpected inflation?
And that’s a fair question. I certainly don’t.
But that’s because I’m a relatively young investor with a high risk tolerance. My portfolio is 100% invested in equities.
If I see unexpected inflation in the short-term, I’m relying on my employment income to rise alongside it, rather than my portfolio. My employment income is there to meet my short-term spending needs, so needs to keep up with short-term inflation. My portfolio is there to meet my long-term spending needs, so needs to keep up with long-term inflation. (This is why I’m holding equities, as they have the best shot of beating inflation in the long run.)
But if I was retired, that would be a different story. Now I’d be relying on my portfolio to meet my short-term spending needs.
Inflation-linked bonds would look a whole lot more attractive to me if I had some portion of my spending exposed to inflation, and I was relying on my portfolio to fund it.
As you move from the accumulation phase of building wealth (i.e. you’re growing your portfolio) to the decumulation phase (you’re retired and using your portfolio to fund your lifestyle), the role of bonds in your portfolio changes.
As an accumulator, you’re counting on bonds to reduce your portfolio’s risk, and help mitigate the effects of stock market crashes. Their purpose is to help you reap the rewards from holding equities. While that’s still true as you move into the decumulation phase, you’re now also relying on your bonds to meet your spending needs.
And this is important, because it means you’ll need your bonds to keep up with inflation, so you don’t lose money in real terms.
Unexpectedly high inflation is one of the most significant risks to investors who are relying on their portfolio to fund their spending. And because we’ve seen how strong inflation-linked bonds are at protecting against short-term inflation, linkers seem like a useful way to mitigate that risk.
But the benefits don’t stop there.
3. Asymmetric return payoff
A third reason investors might want to own inflation-linked bonds is due to their asymmetric return profile.
Because of how linkers adjust for inflation, they offer unlimited potential outperformance over nominal bonds in inflationary environments. If inflation spikes to 1,000% (unlikely), inflation-linked bonds would blow nominal bonds out of the water.
On the other hand, in deflationary environments, regular bonds only offer limited potential outperformance over inflation-linked bonds because inflation-linked bonds have a deflation floor. At maturity, an inflation-linked bond investor receives the higher of the adjusted principal value or the original principal value. So you can never receive less than your principal value, even if there’s deflation. This limits the outperformance potential of nominal bonds in a deflationary environment.
What’s even better is that this asymmetric return payoff is in absolute terms on the upside, but on relative terms on downside. It’s a “head I win, tails you lose” kind of situation.
If inflation is higher than expected, you win. Your bonds will keep up with the unexpected inflation, leaving nominal bond holders in the dust. If, on the other hand, inflation is lower than expected, sure you could’ve been better off if you’d owned nominal bonds, but it’s only an opportunity cost – your inflation-linked bonds will still be keeping up with inflation, and you haven’t actually lost any money.
If, on the other hand, I hold nominal bonds to fund my spending and inflation is higher than expected, I experience actual harm. I’m spending more than my bonds are providing me in income, and I’m losing money in real terms.
If I hold inflation-linked bonds during periods of lower-than-expected inflation, I only experience relative, competitive harm in that I could have been beaten by someone else holding nominal bonds. But why should I care much about that?
I’m perfectly willing to incur a relative loss in a period of lower-than-expected inflation, in exchange for avoiding an absolute loss when inflation is higher than expected.
Inflation-linked bonds guarantee your purchasing power remains constant.
And in that sense, it’s probably more helpful to view inflation-linked bonds as a tool to remove the risk of inflation, rather than thinking about whether they’re likely to outperform nominal bonds or not.
Inflation-linked bonds, when viewed in isolation, simply remove the inflation risk from your bonds. We can ignore the risks of expected vs unexpected inflation, because linkers simply index for any inflation.
And if the object of your bonds is to keep up with inflation, then holding inflation-linked bonds seems like a sensible option.
4. As a diversifier
One final reason investors may choose to own inflation-linked bonds has nothing to do with their ability to protect against inflation.
Being issued by the UK government, inflation-linked bonds can also play the role of high-quality bonds, serving as a diversifier to the equity portion of your portfolio.
As with other government bonds, inflation-linked bonds’ lower levels of return means that substituting them for other investments in a portfolio comes with an opportunity cost. Investors must make the decision based upon their own specific circumstances to determine the sizing of their inflation-linked bond allocation, balancing their needs for an inflation hedge with the likely reduction in return that would ensue in ordinary markets.
I personally would be putting inflation protection into the ‘safe’ bucket of my portfolio (which is one of the reasons I’d prefer having short-term inflation-linked bonds in there instead of commodities), so am less concerned about the ‘lower returns’ argument (as I’d be replacing nominal bonds with inflation-linked bonds, whose returns would be much more similar than inflation-linked bonds compared to equities).
In effect, by adding inflation-linked bonds to a portfolio of nominal bonds, you’re diversifying your bond exposure. On the off-chance your nominal bonds don’t provide the protection you expect during a crash, you’ve got another set of government bonds there just in case.
We saw in this post, titled ‘What’s the best crash protection for you portfolio?’, that UK inflation-linked bonds perform well when equities crash:
But that only looks at one index for inflation-linked bonds – long-duration global inflation-linked bonds hedged to sterling.
Let’s dig a bit deeper.
What we really want to do if we’re looking at inflation-linked bonds vs nominal bonds is to compare both UK and global linkers to both UK and global nominals. So that’s what I’ve done here.
The blue bars are both inflation-linked bonds – one is a UK inflation-linked bond index, one is a global inflation-linked bond index. The three green bars are nominal bonds – one is UK long-duration, one is UK medium-duration, one is global medium-duration.
I’ve used a number of indices in the analysis, which are used as the benchmarks for some of the funds we’ll be looking at in the next part of the series, as they have a longer track record than the funds themselves. Details of which indices relate to which funds are below the chart:
Source: Bloomberg. UK linkers (21.5y) is the Bloomberg UK Govt Inflation-Linked All Maturities TR Index (the benchmark for INXG/GILI/Vanguard UK Inflation-Linked Gilt Index Fund). Global linkers (21y) is the Bloomberg World Govt Inflation-Linked All Maturities Hedged GBP (the benchmark for GILG/XGIG). UK nominals (21.7y) is the Bloomberg UK Govt 15+ Years Float adjusted TR Index (the benchmark for Vanguard UK Long Duration Gilt Index Fund). UK nominals (12y) is the FTSE Actuaries UK Gilts TR Index (the benchmark for IGLT). Global nominals (8.7y) is the FTSE WGBI Hedged GBP (the benchmark for IGLH).
A few thoughts from this chart:
- All bonds provided great protection from crashes, and all served as reliable safe-haven holdings.
- There isn’t much different in protection – either when looking at linkers or nominals – of whether you buy sterling bonds versus global bonds hedged to sterling. Both are great.
- Owning shorter duration tended to help in the largest crashes (2000 and 2008), but longer duration tended to help in the more recent smaller crashes.
- Linkers, in general, have tended to rise slightly less than nominals during equity corrections. So nominals, I suppose as we’d expect due to their better liquidity and reputation for being the premier safe-haven asset, tend to perform better during crashes. But the difference is marginal, and dependent on duration.
Inflation-linked bonds do a great job at protecting against short-term inflation. They’ll only outperform nominal bonds if the short-term inflation is unexpected, as any expected inflation is already reflected in the price difference between nominal and inflation-linked bonds. This inflation protection is particularly useful for those who rely on their bonds to fund their spending.
Inflation-linked bonds also provide an asymmetric return payoff, which has the added benefit of being absolute on the upside and only relative on the downside, as well as providing great protection against equity market crashes.
Now we’ve seen a few reasons why investors might choose to invest in inflation-linked bonds, the next part of the series will have a look at some of their drawbacks.