Inflation‐Linked Bonds

Abstract

In many regimes, inflation is arguably the largest systematic bond risk factor. As such, inflation-linked bonds are as close as the market has gotten to the riskless asset, the ultimate real return investment. The issuer market is dominated by sovereign entities willing to take on inflation risk to reduce interest payments, manage the economy, and match certain payments to cash flows. They are used by long and short-term investors interested in inflation hedging, managing risk, consumption smoothing, asset allocation, and as a basis for inflation-linked derivatives. The basic structure of inflation-linked bonds is unique in that it pays a return equal to actual accrued inflation plus a real interest rate. Consequently, an inflation bond responds uniquely to market and other forces such as economic growth, expected inflation, interest rates and taxes. Investors should therefore consider the effect of such forces on the behavior of an inflation bond's return, current yield, volatility, duration, beta, term structure, and other factors. These factors suggest uses for inflation-linked bonds in liability matching, diversified portfolios, and inflation “trading.”