To The Moon

Inflation-linked bonds are bonds designed to protect the buyer against inflation. The first inflation-linked bond was issued by the Commonwealth of Massachusetts in 1780. In the 1960s, emerging markets began to issue inflation-linked loans. In 1980, the UK was the first developed market to start issuing inflation-linked loans. Several other countries followed: Australia, Canada, Mexico, and Sweden. It was not until January 1997 that Treasury Inflation-Protected Securities (TIPS) were first issued in the United States, and it is now the largest inflation-linked market worldwide. In Europe, France, and Italy in particular issue inflation linkers. Occasionally a company also comes out with an inflation linker, but the vast majority are government bonds.

The operation of an inflation-linked bond is simple. The fixed coupon is paid on the principal that accrues with inflation. So, for example, a coupon always remains 2 per cent, but instead of 2 per cent over nominal 1,000, it is 2 per cent over nominal 1,000 adjusted for inflation since issuance. This also means that whoever buys an inflation-linked bond that the inflation already accumulated must be bought along with it. As such, the buyer therefore always receives 2 per cent over an amount equal in purchasing power. This is a major attraction of an inflation-linked bond because anyone looking back in history will see that it is not easy to keep up with inflation with investments alone. In the long run, bonds barely succeed and really only equities. A bond that can offer 2 per cent real return plus inflation is very attractive for long-term investors.

The appeal of inflation-linked bonds was recognised almost immediately by pension funds. Usually, funds have nominal liabilities but ambitions to also compensate for inflation. Without taking on additional risk, inflation-linked bonds lend themselves very well to this.

Since there are inflation-linked loans, the difference in yield between regular bonds and inflation-linked loans makes it possible to split the yield into a real part and an inflation part. That inflation part is then called inflation expectations. Strictly speaking, this is correct because the tipping point (break-even) is at the price-in inflation expectations. In theory, arbitrage ensures that the market makes the best possible estimate of future inflation. Now that is nice in theory, but in practice, it is not so bad (or disappointing). Early last year, when inflation was still low, inflation expectations for the next 10 years were also low (at just over 2 per cent). Inflation-leftists are thus unable to predict future inflation even remotely correctly. Despite rising inflation since then, inflation expectations have never gone much above 3 per cent. This is good news for holders of inflation-linked bonds because they are not compensated 2 or 3 per cent, but now more than 8 per cent. The reason for this anomaly is that in the UK, among others, only pension funds buy inflation-linked bonds. For pension funds, these loans are so attractive that they were extremely overvalued. Outside the UK, this is much less the case, but in the US, for example, the Federal Reserve is now the largest owner of TIPS. At the end of 2019, it was still 10 per cent of the total, now more than 25 per cent. The remarkable thing, then, is that the Fed bases its policy partly on a market it manipulates itself.

In the real world, nobody relies on inflation expectations for the next 10 years. When it comes to wage banding and new contracts, they mainly look at the here and now (inflation) and possibly price trends for the next 12 months, but they do not look much further. It is therefore completely irrelevant for central bankers to try to steer on long-term inflation expectations, as they do not give an accurate picture of current inflation anyway.

Inflation linkers are interesting when actual inflation exceeds what is priced in. Now, the 10-year TIPS has about 2.5 per cent inflation priced in annually. Inflation is likely to come in between 3 and 4 per cent over the next 10 years and possibly overshoot. Since there is now a real positive return, it is, therefore, possible to protect assets against inflation (something that normally already required investing a decent percentage in equities) and achieve a real positive return on top of that. In fact, it is the only way to still invest in bonds with high duration and get protection against rising interest rates, to the extent that they stem from higher inflation (expectations).