Protecting against inflation

After several decades of low inflation, investors are now again facing probably a somewhat longer period of higher inflation. Inflation comes at the expense of purchasing power, and this touches on the main risk of investing, which is the permanent loss of wealth (purchasing power). One way to mitigate this risk is through inflation-linked bonds. Ordinary bonds are sensitive to changes in interest rates and therefore inflation. Short-term bonds also suffer from this, albeit much less than long-term bonds. Hence, since 1981 in Great Britain and since 1997 in the United States, there have been (government) bonds that provide protection against inflation: the so-called "inflation-linked bonds" or "index-linked bonds" for short. In the United States, these bonds are called TIPS: Treasury Inflation-Protected Securities. In Europe, France, Italy, Greece and Germany also issue them.

The special feature of inflation-linked bonds is that the interest payment is increased when inflation rises. The purchasing power of the payouts is thus maintained. The principal amount of the bond also increases (in most, but not all, cases) by the rate of inflation each year. When the bond is redeemed at the end of its term, the investor is paid an amount that represents the same purchasing power as when the bond was purchased. Inflation-linked bonds are the only fixed-income securities that provide protection against inflation. The inflation-linked bond market is now $2.8 trillion, of which $1.3 trillion is accounted for by U.S. TIPS. In Europe, France (OATEi) has 275 billion outstanding, Germany 85 billion, Italy 178 billion and Spain 82 billion.

In the United States, the inflation definition of the CPI is used; in Europe, it is the HICP-ex tobacco. France also has loans that use the French CPI as a starting point. The coupon yield on an inflation-linked loan is the real yield. So on a 2 percent inflation-linked loan, an investor gets a 2 percent real return and, above that, compensation for all inflation during the term. This is particularly interesting in times of relatively high inflation because although equities are well resistant to inflation, interest rate increases resulting from higher inflation can put pressure on valuations there. In this respect, achieving a real positive return in times of high inflation can only be guaranteed with an inflation-linked loan.

When investors compare the return on an inflation-linked loan with a normal loan of the same maturity, there is a break-even point at which both loans give the same return. Suppose the real return is 2 percent and the nominal return is 5 percent then the return on the inflation-linked loan is higher at the point when inflation exceeds 3 percent. This break-even rate is also considered the market estimate of future inflation. At the same time, other factors, including supply and demand, influence this "expectation," making its predictive value zero. In any case, the current wave of inflation did not see the market coming. A distorting effect also comes from the high demand, mainly from the institutional side (pension funds) there is a natural demand for inflation-linked bonds. After all, they are ideal for both fulfilling the obligation of providing a nominally guaranteed pension and, in addition, these funds can even fulfil the real ambition of compensating for inflation. So it may be that the market for UK inflation-linked bonds was fully owned by UK pension funds last year. That combined with leveraged LDI programs did not prove to be a happy combination. UK inflation-linked bonds have long been far too expensive for investors because of the strong interest of those pension funds, but have now normalized. The advantage of British Index-Linked Gilts is that they are linked to the RPI, the retail price index, an index that usually comes out somewhat higher than the CPI.

Current break-even inflation in the United States is slightly above 2 percent on just about every maturity. This is remarkable given the current much higher inflation rate and the risks that inflation will continue to move higher in the coming years. Moreover, the chances of an inflation rate below 2 percent for longer periods of time actually seem small. In Europe, break-evens are somewhat higher. This is justified given the persistent nature of European inflation, a result of the greater role of the government and much less flexibility in the labour market. As a result, inflation may also exceed break-evens for a longer period of time in Europe in the coming years. Of course, central banks can decide to fight inflation at any cost, but in the context of high debt burdens, somewhat higher inflation is a solution rather than a problem.