Skip to content

Inflation-linked bonds – Why the private investor must take action now!

After many years of low inflation and meager interest rates, the spectre of inflation has returned.

Inflation is rising to levels not seen in a long time...

After many years of low inflation and meager interest rates, the spectre of inflation has returned.
  • 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 graph

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

Inflation-linked bonds are often compared with fixed-rate government bonds of similar maturity (whose coupon payments and capital do not rise due to inflation) in assessing their returns. The yield on a fixed-rate government bond is called the nominal yield. This yield is negatively affected by inflation so that the so-called real yield is reduced: The purchasing power of the interest coupon and that of the redemption amount have been diminished by inflation during the investment period. The returns on inflation-linked bonds, on the other hand, are and remain stable in inflation-adjusted terms, i.e., investors always receive constant “real” returns.

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.

Oil price evolution
Private Altersvorsorge - Rentenrechner
Is your portfolio protected against inflation?
Contact now an experienced investment advisor from Genève Invest

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

Arguably, the more important risk of investing in inflation-linked bonds is interest rate risk, i.e. the possibility of an improvement in the interest rate landscape for investors during the life of the relevant bond. Such a change would make the bond less attractive relative to bonds issued later and, accordingly, lower its price. The longer the maturity of a bond, 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.

Genève Invest's assessment: Inflation-linked bonds:

“Shares and corporate bonds are definitely the better alternative for private investors.”

Conclusion

Genève Invest considers inflation-linked bonds as one of several ways to hedge a portfolio against inflation. However, inflation-linked bonds are mostly based on government bonds and thus have very low underlying yields. It should also be remembered that central banks usually raise interest rates when inflation occurs and lasts longer. And the rise in interest rates has a negative effect on the prices of government bonds, so that price losses are imminent.

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

Find out why an independent consultant is essential to managing your portfolio

Discover the investment strategies that we have developed for you.

We call you without obligation.

Fill out the form and we will contact you to give you more information.
Fields marked with * are required, other information can help us  improve our proposal.
Genève Invest accepts mandates starting at € 100.000