Investing in Inflation Protection

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Both inflationary and deflationary concerns have emerged as global economies continue to struggle with recovery. In this confusing environment, inflation-protected bonds can play an important role in plan sponsors’ asset allocation dilemma especially in light of yesterday’s Fed announcement of Quantitative Easing (II) implementation plan. We find that IPBs have exhibited some distinct differences from other asset classes during the past decade. We highlight the following:1. IPBs as an asset-class-level inflation hedge: We find that IPBs have provided reasonable protection against inflation historically. In the US and UK, IPBs moved closely with inflation, outperforming equities and nominal bonds in inflationary periods. Nominal bonds tended to move inversely to inflation. Commodities also moved strongly with inflation but experienced greater declines when inflation fell.IPBs in a deflation scenario: Nominal bonds had stronger protection (or put optionality) on deflation relative to IPBs during the last decade. During a shift from inflationary to deflationary expectations, existing nominal bonds have benefited from having a relatively wide inflation expectation spread built into the coupon. In a prolonged deflation scenario, holders of shorter dated new issue IPBs benefit from a guaranteed redemption value, the so-called “deflation floor”, which is prevalent in IPBs issued by some countries such as the US. 2. IPBs for portfolio diversification: The correlations of IPBs with other asset classes have been relatively low for equities, commodities, and real estate, and only slightly higher than correlations of nominal bonds with those assets. IPBs exhibited relatively low correlations over the last decade with other asset classes, both from a domestic perspective and the perspective of a US international investor, supporting their attractiveness for diversification purposes.