How to Find Relative Value in Inflation-Linked Bonds

“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.”

Central banks around the world have been targeting higher inflation levels over the past year, with 2018 seeming to be the year where your haircut will finally cost more. Any signs of alopecia would be pure coincidence.

Inflation-linked bonds and inflation swaps are the most popular instruments to protect against inflation. Inflation-linked bonds are securities where the principal and/or coupon is tied to a consumer price index, thus protecting the investor’s purchasing power at the time of maturity. While linkers are only a small part of the overall fixed income universe, it is worth looking at them in the context of a diversified portfolio.

The Market

The overall inflation-linked bond market is nearly $3 trillion in size and is dominated by a few larger issuers. US TIPS are almost 40% of the amount outstanding. Other large issuers are primarily European, with United Kingdom issuance totaling €733 billion, France issuance totaling €230 billion, and Italy issuance totaling €154 billion of outstanding debt. This article will mainly focus on analyzing European inflation-linked bonds. 

Where Do Linkers Fit In a Portfolio?

Due to their mandated long investment horizon, pension schemes and life insurers are a natural target audience for these securities. They are also a good diversification play for any long-term investor looking to preserve purchasing power.

As the subject of rising consumer prices has garnered more attention from the media and asset managers over the past several months, this asset type has seen significant institutional inflows. The chart below shows EPFR fund flow data depicting an upward trend for Western Europe beginning in November 2017.

Today, the inflation adjustments of most European linkers are tied to the Euro HICP - ex tobacco index. France and Italy also have debt outstanding linked to their respective country CPI indices.

Inflation Swaps and Break-Even Inflation Rates as Future Indicators

As with most things in financial markets, attractiveness of an asset class tends to revolve around future expectations. Linkers are no exception. Projected levels of CPI indices are one driver impacting the pricing for linkers and can be found in swap data. In an inflation swap, party one pays a fixed rate on a notional principal amount, whereas party two pays a floating rate linked to an inflation index. The following chart indicates that inflation expectations have already risen significantly over the past nine months.

A second way to look at future inflation is using break-even inflation rates (BEI). These rates mark the difference between the yield of a nominal bond and the real yield of an inflation-linked bond of the same maturity and credit quality. If average annual inflation equals the BEI rates, investors would be indifferent between holding a nominal bond or an inflation-linker. Put another way, if realized inflation is higher than break-even rates, then inflation-linkers would outperform nominal bonds of the same maturity. BEI rates can therefore be used to determine relative value between nominal and inflation-linked bonds.

Looking at the BEI curve for France, the chart below resembles the one of the inflation swaps above. This is not surprising as both are future inflation gauges and the OATeis are also tied to the Euro HICP – ex Tobacco index. 

One reason for minor discrepancies between the two curves is that the issuing volume of linkers is still small relative to nominal bonds. Comparing liquidity scores provided by ICE, we see that nominal bonds tend to be more liquid than linkers of same maturity and credit quality. As a result, we need to account for a liquidity premium. Another reason for differences between the two curves is that any inflation adjustment is usually applied to the bonds with a three-month lag.

So Will it Still Pay Off to Invest in Inflation Linkers?

Whether inflation linkers are still a good investment depends on your inflation expectations. In the event that Eurostat’s reported inflation numbers surprise on the upside, linkers would rise further. Vice versa, if the market has anticipated too much inflation, there would be a correction. As shown in the chart below, analysts surveyed by FactSet have been gradually raising their Eurozone inflation forecasts over the last few months. While this is not as accurate as using the exact inflation series to which the bonds are tied, this chart tells the same story as the swap curves above.

A Relative Value Approach

Assuming an investor believes that realized inflation will be higher than what is currently priced in the market, they are left with the question of which bonds to pick. One approach to answering this is to use relative value analysis. By comparing a security’s actual spread with a fitted spread, it is possible to divide the bonds into rich or cheap buckets. If the issue is trading above the fitted spread, it is trading relatively cheap compared to other linkers of the same issuer. The table below details this analysis for the UK market when solving for a polynomial function 3^rd degree. 

Hedging Inflation Risk

Beyond relative value or asset type attractiveness, understanding proper risk management is imperative to avoiding downside surprises. Insurers or pension funds want to be hedged versus their liabilities, avoiding interest rate and inflation risk. In hedging interest rate risk, there is the well-known concept of DV01. This measures the increase in market value for a 1 bp parallel downward shift in the yield curve. Dividing a portfolio’s DV01 by the benchmark or liability profile’s DV01 will return the hedge ratio and indicate how well a portfolio is protected to changes in interest rates.

A similar concept is available for inflation risk and is known as IE01. This measures the change in market value for a 1 bp change in inflation. Analogous to DV01, we can calculate a hedge ratio by dividing the portfolio’s IE01 by the benchmark or liability’s IE01 to show how well it is protected to changes in inflation. The chart below displays both ratios year-to-date for a sample portfolio. 

Regression Hedging Using Inflation-Linked and Nominal Bonds

As discussed above, relative value can be found between nominal bonds and inflation-linkers. Traders and portfolio managers can use DV01 hedges to make bets on future inflation levels. This can be achieved by entering a DV01 neutral short position in a nominal bond and an offsetting long position in an inflation-linked bond. To improve accuracy this should be adjusted by the slope of the real and nominal yields. The table below compares two German issues where the yield slope is calculated over six months using real yields as independent and nominal yields as dependent variables. The difference between nominal and real yields is the BEI rate.

The following formula shows the amount of inflation-linked bonds to be purchased to remain DV01 neutral: 

Plugging in the numbers from the above example and assuming the short position has a size of €1 million we arrive here:

This result indicates that for every €1 million sold in nominal bonds we should purchase €861,963 in inflation-linked bonds. Since this trade is DV01 neutral for a 1 bp change upwards/downwards, it will not lose/gain value.

Fixed Income Attribution Using Inflation Effects

We can use a fixed income performance attribution model to analyze the magnitude of the ex-post and ex-ante inflation effects. The ex-post inflation effect quantifies the portion of benchmark relative return that can be attributed to changes in inflation uplift. Ex-ante inflation effect measures the portion of a bond's price return that can be attributed to movement based on inflation expectations for an inflation-linked security. Ex-ante inflation effect is calculated as the price percent change caused by holding the OAS of the bond constant and pushing the settlement date forward, while applying the ending date’s inflation swap projection. The table below illustrates both effects. 

In summary, inflation-linked securities have historically been viewed as a minor part of the investable universe and are often totally ignored. However, the purchasing power protection, diversification, and ease of analysis they provide make them worth exploring in more detail.