Inflation-linked Bonds Research Articles

Euro area inflation linked debt: An evaluation

How would the fiscal burden of Euro area (EA) countries have evolved without the issuance of inflation linked bonds (ILBs)? Could debt management through ILBs have decreased their sovereign debt-to-GDP ratio? By exploiting a new dataset on ILBs and the market value of debt in Germany, France, Italy and Spain in 2014–2022, I calculate the holding period return for investors in both nominal and real debt. Based on the government budget constraint, I conduct simulations that demonstrate the significant first-order effects of debt structure choices. Without ILBs the fiscal burden of the largest EA economies would have decreased by around 1% of GDP but in the case of Italy, it would have increased. Timing was also a relevant factor. Germany effectively controlled the cost of funds by managing its share of real debt, while Spain increased it by issuing ILBs when it was expensive. Slight ILB share adjustments could have alleviated their fiscal burden: Germany by 0.9%, France by 3%, Italy by 7%, and Spain by 1.8%.

La efectividad de los distintos tipos de activos como cobertura frente a la inflación

Rationale The current period of high inflation makes it difficult for investors to maintain their profitability targets in real terms. Against this background, it is important to analyse the returns on different types of assets recorded in this and past inflationary episodes. Takeaways •In the past, both commodities and inflation-linked bonds have generated positive real returns during inflationary periods, while conventional sovereign bonds and general stock market indices have yielded negative real returns. •In the current inflationary episode energy-related assets have generated the highest returns, while in the United States residential real estate has also performed well. •In the recent period, both in the euro area and the United States investors have increased their holdings in investment funds specialising in inflation-linked bonds, and have reduced their holdings in conventional bond and equity funds.

A Study on the Criteria for Investment in the Bond Market

This paper uses relevant information to illustrate some of the factors that influence investors' choice of bonds: by analyzing a cross-section of firms to conclude that insurance companies with stronger regulatory capital constraints tend to seek higher yields; according to the findings of a study into the added value of inflation-linked bonds in a portfolio, inflation-linked bonds widen the mean-variance efficient frontier for investors holding nominal bonds and stocks by simulating credit spreads that are more like those actually seen in the market and modeling leverage as a mean-reversion; and the findings indicate that market liquidity is neutrally or favorably impacted by portfolio trading transparency. This was established by using a controlled experiment to investigate the impact of transparency on the liquidity of the BBB bond market. In addition, some suggestions are put forward for some related investors, and the future research direction is also proposed at the end of the article.

The Capital-Protection Capacity of Emerging Markets Inflation-Linked Bonds

The authors investigate the capital-protection property of inflation-linked bonds in an international context during the period 2012 to 2022. Inflation-linked bonds compensate domestic investors for loss of local purchasing power. Whether the bonds protect foreign investors effectively depends on the inflation levels they endure and on the currency hedging costs. The authors study the case of an American investor who considers allocating inflation-linked bonds to emerging markets rather than to US bonds in view of reaping higher inflation compensation. Their results suggest that during the past decade such allocation would have been worthwhile, even when taking latent risks, notably country default, into account.

Inflation-linked bonds in incomplete markets with sunspots

AbstractThis paper investigates the impact of the introduction of inflation-linked bonds, which incur transaction costs when traded, on the monetary economy with sunspots. This paper shows that there always exists a certain range of positive transaction costs, where both monetary and bond markets are active. This implies that on top of governments, profit-seeking financial entrepreneurs also have the incentive to issue these bonds. This paper also displays how financial innovation on the indexed bond can be Kaldor improving, even if not necessarily Pareto improving. This finding indicates that together with lump-sum tax policies, the government can attain consensus among consumers on bond issuance.

Price impact, strategic interaction and portfolio choice

This paper studies the portfolio choice of two large investors who act strategically because their trading affects interest rates. Each investor chooses her optimal portfolio conditional on the portfolio of the opponent. Equilibrium portfolios and their performance depend on the investor’s characteristics (risk aversion and return impact) and on the characteristics of the opponent (risk aversion and return impact). Depending on the interplay among these characteristics, strategic interaction can (i) increase or decrease risk taking incentives, as compared to the Merton-style portfolio, (ii) induce the more risk-averse investor to invest relatively more in the risky asset and (iii) change the role of inflation-linked bonds from hedging instrument to borrowing opportunity.

Immunization Strategies for Funding Multiple Inflation-Linked Retirement Income Benefits

Protecting against unexpected yield curve, inflation, and longevity shifts are some of the most critical issues institutional and private investors must solve when managing post-retirement income benefits. This paper empirically investigates the performance of alternative immunization strategies for funding targeted multiple liabilities that are fixed in timing but random in size (inflation-linked), i.e., that change stochastically according to consumer price or wage level indexes. The immunization procedure is based on a targeted minimax strategy considering the M-Absolute as the interest rate risk measure. We investigate to what extent the inflation-hedging properties of ILBs in asset liability management strategies targeted to immunize multiple liabilities of random size are superior to that of nominal bonds. We use two alternative datasets comprising daily closing prices for U.S. Treasuries and U.S. inflation-linked bonds from 2000 to 2018. The immunization performance is tested over 3-year and 5-year investment horizons, uses real and not simulated bond data and takes into consideration the impact of transaction costs in the performance of immunization strategies and in the selection of optimal investment strategies. The results show that the multiple liability immunization strategy using inflation-linked bonds outperforms the equivalent strategy using nominal bonds and is robust even in a nearly zero interest rate scenario. These results have important implications in the design and structuring of ALM liability-driven investment strategies, particularly for retirement income providers such as pension schemes or life insurance companies.

A stochastic investment model for actuarial use in South Africa

In this paper, we propose a stochastic investment model for actuarial use in South Africa by modelling price inflation rates, share dividends, long-term and short-term interest rates for the period 1960–2018 and inflation-linked bonds for the period 2000–2018. Possible bi-directional relations between the economic series have been considered, the parameters and their confidence intervals have been estimated recursively to examine their stability, and the model validation has been tested. The model is designed to provide long-term forecasts that should find application in long-term modelling for institutions such as pension funds and life insurance companies in South Africa
 Keywords: Stochastic investment models; price inflation; share dividend yields; share dividends; share prices; long-term interest rates; short-term interest rates; inflation-linked bonds; South Africa

Relative pricing of French Treasury inflation-linked and nominal bonds: an empirical approach using arbitrage strategies

This paper investigates whether arbitrage opportunities exist between inflation-linked bonds and nominal bonds on the French Treasury market. Following arbitrage theory, we apply the risk hedging concept: we set up self-financing portfolios hedged against risks through durations of different orders. Perfectly hedged portfolios are those with a zero initial and a zero final value. The results show arbitrage gains when the first three duration orders are implemented, but they are not significantly different from zero when a fourth-order duration is added. Furthermore, a regression of arbitrage gains on the illiquidity measure of nominal and index Treasury bonds provides evidence that the illiquidity of inflation-linked bonds significantly explains arbitrage gains, whereas the illiquidity measure of nominal bonds does not.

US Government Bond Liquidity during the COVID-19 Pandemic

US government bond illiquidity measures began rising during the last week of February 2020. Several of them surpassed the Great Recession levels during the second week of March. Illiquidity spikes do not seem to match with proposed explanatory events. The illiquidity measures of the most actively traded securities declined after the first Federal Reserve intervention, but normalizing the liquidity of other bonds required the second intervention. Liquidity measures were mostly back to normal by late April. The inflation-linked bonds illiquidity spike was milder but more persistent and less correlated with Federal Reserve actions compared to nominal Treasuries.

Inflation-Linked Bonds, Nominal Bonds, and Countercyclical Monetary Policies

Although inflation-linked bonds have many advantages, nominal bonds are the most important instrument to finance public debts throughout the world. One explanation that the literature has offered is that nominal bonds make countercyclical monetary policies more effective. This paper reconsiders this argument with a model that features an inflation risk premium in the nominal bonds interest rate. In this model, nominal bonds help to stabilize the economy, but also add to debt service costs. The paper finds that the debt service costs channel is very powerful: in the case of discretionary policymaking, inflation-linked bonds always outperform nominal bonds. The case of commitment qualifies this result. Still, also commitment cannot explain the occurrence of large stocks of nominal bonds alongside small stocks of inflation-linked bonds.

Price Pressure in the Government Bond Market: Long-term Impact of Short-term Advice

This paper analyzes the systemic impact of massive pension funds' portfolio reallocations triggered by a financial advisory firm. We analyze the main channels by which government yields are affected and trace their impact on households and firms' financing costs. We document significant and persistent price pressure in the domestic government bond market after portfolio switching recommendations. Further, we find persistent changes in government yields, particularly in long-term inflation-linked bond yields, triggered by changes in the term premium component. Consistent with the relevance of inflation-linked bonds as the primary benchmark in setting interest rates, we find a substantial impact on firms' and households' financing costs.

Optimal asset allocation for a DC plan with partial information under inflation and mortality risks

We study an asset allocation stochastic problem for a defined-contribution pension plan during the accumulation phase. We consider a financial market composed of a risk-free asset, an inflation-linked bond and the risky asset. The fund manager aims to maximize the expected power utility derived from the terminal wealth. Our solution allows one to incorporate a clause which allows for the distribution of a member’s premiums to his surviving dependents, should the member die before retirement. Besides the mortality risk, our optimization problem takes into account salary and the inflation risks. We then obtain closed form solutions for the asset allocation problem using a sufficient maximum principle approach for the problem with partial information. Finally, we give a numerical example.

Portfolio selection with inflation-linked bonds and indexation lags

We derive the price of inflation-indexed bonds of which the payments are linked to a lagged price index and solve for the optimal bond portfolio under both inflation and indexation lags in closed form. We show that indexation lags increase the number of state variables characterizing both the bond prices and the optimal portfolio. The lag-induced state variables affect the future investment opportunity and hence further arm investors with the tools for hedging inflation risk that is, however, unhedgeable if there is no indexation lag. We find that the optimal portfolio accounts for the indexation lags by also exploring the historical information and increases investors’ welfare. Therefore, we document a positive effect of the indexation lags that are typically considered as a type of market friction.

Portfolio Selection with Inflation-linked Bonds and Indexation Lags

We derive the price of inflation-indexed bonds of which the payments are linked to a lagged price index, and solve for the optimal bond portfolio under both inflation and indexation lags in closed form. We show that indexation lags increase the number of state variables characterizing both the bond prices and the optimal portfolio. The lag-induced state variables affect the future investment opportunity and hence further arm investors with the tools for hedging inflation risk that is, however, unhedgeable if there is no indexation lag. We find that the optimal portfolio accounts for the indexation lags by also exploring the historical information and increases investors' welfare. Therefore, we document a positive effect of the indexation lags that are typically considered as a type of market friction.

Inflation – Indexed Bonds and Derivatives

This chapter provides an introduction to index-linked securities, including inflation-indexed securities such as TIPS issued by the U.S. government and index-linked gilts issued by the UK government. Basic concepts of bond purpose and design are described in summary, followed by a detailed look at inflation-linked bond yield analysis. This then enables us to look at the concept of the inflation term structure. The second half of the chapter considers inflation-linked derivatives such as inflation-linked bond swaps, year-on-year inflation swaps, and real annuity swaps, together with a look at the use of inflation derivatives for hedging purposes. This includes hedging pension liabilities and restructuring bond portfolios. We then review constructing the inflation term structure and pricing inflation derivatives.

Inflation-Linked Bonds as a Separate Asset Class: Evidence from Emerging and Developed Markets

One of the key goals of strategic asset allocation is protection against inflation. High inflation eats up real returns, causing a damaging effect on a portfolio of bonds and equities. Inflation-linked bonds (ILBs) were introduced to shield the purchasing power of a portfolio from inflationary conditions by linking portfolio returns to inflation, over a bond’s life term. The current research evaluates the acceptability of ILBs as a separate asset class and as an inflation hedge. It uses data from four emerging and four developed markets for a period of five years, that is, 2011–2016. The study employs multiple regression, cross-correlations and mean-variance spanning techniques to demonstrate the abovementioned benefits of ILBs. The findings of the study establish an advantage of excess returns provided by ILBs over nominal bonds under varying inflationary conditions. An improvement in mean-variance efficiency is found when ILBs are added to a portfolio. Overall, the study contributes to the body of knowledge by suggesting that ILBs can be included in a portfolio to hedge, as well as to improve its strategic asset allocation.

Portfolio decision with a quadratic utility and inflation risk

This paper considers a portfolio selection problem with a quadratic utility of consumption, which is symmetric with respect to a bliss point. At bliss point, the utility function has its maximum value and further consumption lowers the utility. In the presence of inflation risk, we introduce an inflation-linked index bond to manage the inflation risk and derive explicit expressions for the optimal consumption and portfolios by applying duality method. Based on quantitative results, we see that inflation-linked index bond plays an important role in choosing consumption and portfolio rules.

Simulating historical inflation-linked bond returns

Abstract Empirical research on the benefits of investing in inflation-linked bonds usually relies on a limited number of observations due to the relatively recent introduction of these assets. We estimate models for the break-even inflation rate and use these to create hypothetical inflation-linked bond returns. We compare these with the return on actual inflation-linked bond returns on a recent sample and find that surveys of professional forecasters and moving average models perform best. We confirm these findings for a sample of 19 international inflation-linked bond markets. Using surveys of professional forecasters, we create hypothetical inflation-linked bond return series for 41 countries starting in 1987 or later depending on the availability of nominal bond markets. These simulated series can be used by asset allocation researchers, but an average correlation of 0.7 means that the simulated series are at best reasonable proxies for real data on inflation-linked bond returns. This cautionary note is also relevant to appreciate existing research using simulated inflation-linked bond returns.

House Rent - Price Ratios : An International Comparison

Tenants have liquidity constraints that limit volatility in nominal rents, leading houses to become bond-like. The incidence of shocks on rental yields is near zero. For 1980–2014 in Germany and Japan, houses are bond-like, with tenants bearing less than 5% of asset-price shocks. In the United States and United Kingdom, houses are inflation-linked bonds earning real yields of 4%, with tenants bearing 20% of shocks. In Korea, a capital market leads tenants to bear all price shocks. Only there is the rental yield perfectly negatively correlated with capital gains, a requirement for the user cost of housing.