Inflation is rising to levels not seen in a long time...
- In the eurozone, inflation rose to 4.9 % in January 2022.
- In the USA, it was even 7.5%.
Is this just a temporary rise in the inflation rate or a persistently remaining inflation? Thinking about the latter will also make you think about protecting your assets against inflation, which should always be part of a long-term investment strategy.
Inflation-protected bonds are one form of protection. An inflation-linked bond – also called an inflation-indexed bond or inflation bond – is usually issued by the government of a country.
Its cash flow is the same as a regular government bond with regular coupon payments and repayment of the total amount at maturity. In this case, however, the coupon and redemption amounts are tied to the inflation rate based on an index. Most inflation-indexed bonds guarantee at least 100 % repayment of capital at maturity, protecting investors from prolonged periods of deflation.
Rising interest rates as a danger for inflation-linked bonds
How to measure the attractiveness of an inflation-linked bond: Strong correlation with the oil price
This difference between nominal and inflation-linked bonds leads us to another crucial concept, the so-called break-even inflation rate. It is the difference between the yield on a nominal fixed-rate bond and the real yield on an inflation-indexed bond of similar maturity and credit quality. Since inflation-indexed bonds are flexible, not having a fixed coupon for the life of the bond and inflation indexation provides an opportunity for higher nominal payments, the interest coupon (before any adjustments based on inflation indexation are made) is generally set lower than for fixed-rate bonds. If inflation is above the break-even rate on average, the inflation-linked investment will deliver better results than fixed-income bonds. On the other hand, if inflation is below the break-even rate, fixed income will outperform inflation-linked bonds.
The current break-even rates of 10-year government bonds (as of March 2022):
- USA: 2.85%
- Great Britain 4.55
- Germany 2.65%,
- Italy 2.47%
- Japan 0.76%
The rates reflect the different long-term inflation expectations in the individual markets. They are currently at the highest level since the 2007/2008 financial crisis in most countries.
As can be seen in the chart below, the break-even inflation rate has correlated strongly with the rise in the oil price since March 2020.
Risks of inflation-linked bonds
The risks associated with inflation-linked bonds primarily pertain to government credit default risk and interest rate risk. Government credit risk refers to a government’s unwillingness or inability to meet its credit obligations. Since inflation-linked bonds promise a large part of their coupon payments in late maturity years, the average repayment is even more skewed towards maturity. Thus there is a somewhat higher credit default risk compared to regular bonds. However, government risk is considered low for most developed country governments.
Arguably, the more critical risk of investing in inflation-linked bonds is interest rate risk, i.e., the possibility of an improvement in the interest rate for investors during the life of the relevant bond. Such a change would make the bond less attractive than subsequently issued bonds and, accordingly, lower its value. The longer the bond’s maturity, the greater the change in the bond price in response to changes in the market interest rate, and accordingly, the greater the interest-rate risk, a mechanism that also applies to classic bonds.
Interest rate risk as the most important risk
Genève Invest's assessment: Inflation-linked bonds:
“Shares and corporate bonds are definitely the better alternative for private investors.”
Conclusion
For these reasons, it makes sense to also think about alternatives for hedging an asset against inflation. In particular, this can be done by investing in real assets such as shares. However, high-yield corporate bonds also offer good protection against inflation due to their high interest coupons.
For more information on why inaction will be punished from now on and what is the best investment in the face of inflation, follow our financial insights
