Inflation-indexed bonds.

• Author: Viceira, Luis M.

Introduction

Inflation-linked bonds, which in the US are known as Treasury Inflation Protected Securities (or TIPS), are bonds that pay investors a fixed inflation-adjusted coupon and principal. Their nominal payments adjust automatically with the evolution of a price index describing the cost of a basket of consumer goods such as the Consumer Price Index in the US. Although the popular press often labels inflation-indexed bonds as "exotic securities," nothing could be farther from reality.

Inflation-indexed bonds constitute today a significant fraction of outstanding bonds issued by the US Treasury--around 10% of total marketable debt, and more than 3.5% of GDP. Both institutional investors such as endowments and pension funds and retail investors hold them in their portfolios, either directly or indirectly through TIPS mutual funds, ETFs, and asset allocation funds such as target retirement funds. TIPS have become a building block of investors' portfolios. TIPS also play an important role in policy. Central bankers, professional economists, and market observers routinely follow the evolution of "breakeven inflation," or the spread between the yields on nominal government bonds and the yields on inflation-indexed bonds of equivalent maturity, as an indicator of real-time inflation expectations from bond market participants.

The relevance of inflation-indexed bonds to investors and policy makers is not unique to the US. The UK has a longer and even more established tradition of issuing and investing in inflation-linked bonds (or "gilts" as government bonds are known in the UK). Inflation-indexed linkers represent more than 30% of British public debt, equivalent to almost 10% of UK GDP. The UK government is now considering issuing inflation linkers with super-long maturities (in excess of 50 years) and even perpetual inflation-indexed gilts. In the Euro area, France, Germany, and Italy regularly issue inflation linkers, linked to either Euro-area inflation or to domestic inflation. Demand for linkers in both the UK and the Euro area is strong, particularly from pension funds, as pensions in those countries are typically indexed to inflation. After a brief interruption, Japan is re-starting regular issuance of inflation-linked bonds and, among emerging economies, Brazil has become a large issuer of such bonds. Australia, Canada, Chile, Israel, Mexico, Turkey, and South Africa are also economies with non-trivial issuance of inflation linkers. The hedge fund Bridgewater has recently calculated the size of the global inflation-linked market at $2.5 trillion, larger than the high-yield corporate bond market and twice as large as the dollar-denominated emerging market bond market.

My research on inflation-indexed bonds has been focused on understanding the role of these securities in investors' portfolios, their pricing and risk, and the impact of institutional factors on the market for inflation-indexed bonds.

Inflation-Indexed Bonds in Long-Term Portfolios

A traditional idea in investment practice is that cash (e.g., short-term default-free bonds or bills) is the safe asset for all investors. This idea is rooted in a perception that real interest rates are constant. Indeed, if real interest rates are constant, standard models of portfolio choice, whether static or dynamic, show that the optimal investment strategy for investors with low (effectively zero) risk tolerance is a strategy of constantly reinvesting their wealth in default-free real short-term bonds. To the extent that inflation risk is small at short-horizons, nominal short-term bonds are good substitutes for inflation-indexed short-term bonds.

My early research on inflation-indexed bonds with John Campbell shows that this strategy will not be optimal if ex-ante real interest rates vary over time. (1) When future real interest rates uncertain, a strategy of constantly reinvesting wealth in short-term bonds will preserve investors' initial wealth in the face of random shocks to long-term assets, but not necessarily their ability to spend out of this wealth. (2) If real interest rates decline, investors will have to either adjust downward their spending plans to accommodate this reduction in the yield on their wealth, or else deplete part of their wealth to maintain their consumption plans, with the subsequent impact that this reduction in wealth might have on their future welfare.

In contrast to a strategy of constantly reinvesting wealth in short-term bonds, a strategy of investing in inflation-indexed long-term bonds will protect spending, since these bonds will increase in value as real interest rates decline, thus providing the extra cushion investors need to maintain their spending plans without depleting their initial principal. For long-horizon investors, long-term inflation-indexed bonds are the riskless asset. By investing in a portfolio of inflation-indexed bonds whose cash flows match their consumption spending plans, investors can guarantee a riskless consumption stream. (3) Of course, this portfolio of inflation-indexed bonds will experience short-term fluctuations in price, but these will be irrelevant to a long-horizon investor exclusively interested in ensuring a riskless consumption stream.

Our analysis provides support for the traditional portfolio advice that conservative long-term investors should tilt their portfolios towards long-term bonds. However, it does so with an important qualification: the bonds should be inflation indexed. Nominal long-term bonds such as Treasury bonds and notes expose long-term investors to inflation risk. If realized inflation turns out be larger than expected at the time of the investment in nominal bonds, the ability of those bonds to protect real spending will be undermined. By contrast, inflation-indexed bonds are immune to the potentially devastating effects of unexpected inflation.

The insights of this analysis have important implications for the design of savings vehicles for long-term investors, such as investors saving for retirement. It makes clear that assets that preserve capital do not necessarily preserve long-term standards of living. Long-term inflation-indexed bonds, not cash instruments, are the riskless asset for conservative investors who care about financing their long-term spending plans or liabilities, such as investors saving for retirement, traditional pension funds, or endowments. Nominal long-term bonds achieve this objective only when inflation risk is low. The issuance of inflation-indexed bonds by the Treasury has a significant impact on welfare, as it provides long-term investors with a truly riskless long-term investment vehicle.

Real interest risk, inflation risk, and the risk of long-term bonds

Inflation-indexed bonds are the safe asset for long-term investors. But how much riskier is investing in short-term bonds or in long-term nominal bonds from the perspective of a long-horizon investor? Or the risk of investing in long-term inflation indexed bonds from the perspective of a short-horizon investor? To answer these questions, one can apply the tools of modern finance to the analysis of inflation and interest rates to quantify real interest rate risk and inflation risk.

A simple and intuitive way to understand the importance of these two types of risk is to examine the annualized standard deviation (or volatility) across investment horizons of the real return on a strategy consisting of constantly reinvesting capital in T-bills, and the real return on another strategy consisting of buying and holding a long-term zero-coupon nominal bond with maturity equal to each investment horizon under consideration...