Market conditions and when to use inflation-linked bonds

Market conditions and when to use inflation-linked bonds

In the previous modules of the AXA IM Inflation Series, we have looked at what inflation is and how inflation-linked bonds can mitigate the risk of inflation. We’ve covered some of the main principles when valuing inflation-linked bonds and explored the impact duration has. Now, we will discuss what to expect from different inflation-linked bond strategies depending on market conditions.

There are three main approaches to investing in inflation-linked bonds:

1. All maturities
2. Short duration
3. Inflation breakevens

All maturities

All maturities refers to investing in the entire universe of inflation linked bonds which has around 11 years of duration.

These tend to perform best when real interest rates are falling. Whenever interest rates rise, this strategy can deliver positive returns as long as the duration impact is not greater than inflation.

Short Duration

Investors who are willing to capture inflation indexation without being exposed to high duration prefer short duration inflation-linked bonds. In this type of strategy, the main performance will be realised inflation as by definition the sensitivity to interest rates is lower.

Short duration is normally considered to be around 3 years. Investing in short duration bonds should deliver positive returns as long as the sum of realized inflation and real yield is above zero.

Inflation breakevens

The breakeven is the inflation level for which an investment made in an inflation-linked bond equals an investment made in a fixed-rate bond. In simple terms, the breakeven rate is the difference between the real yield of an inflation-linked bond and the nominal yield of a bond with similar characteristics.

This provides the expected average rate of inflation until the bond’s maturity that is embedded in market prices. There are different ways to build a long breakeven strategy. The simplest way is by purchasing inflation-linked bonds and hedging their duration through the sale of nominal bonds or futures.

As this chart shows, inflation breakevens tend to follow realized inflation. A long breakeven strategy will deliver positive returns as long as inflation expectations rise. Since breakevens tend to follow inflation momentum, high but stable inflation may not be the best environment for inflation breakevens.

There are several approaches when it comes to investing in inflation-linked bonds but which one to choose, beyond an investor’s broader portfolio considerations, will depend on the inflationary environment.