As headline inflation continues to cool down in recent months and quarters, after heating up during the second half of 2021 and becoming red hot during 2022, we look at how the two commonly used instruments offering direct exposure to inflation have performed during the recent inflationary period:
Inflation-linked bonds
Inflation swaps
There is published literature analysing and discussing the suitability of inflation-linked bonds’ as a hedge against inflation in diversified portfolios if not held to maturity, compared with inflation swaps.
Returns from holding inflation-linked bonds are driven by:
Coupon rate
Capital appreciation/depreciation
Inflation accretion over the holding period
The primary component of total returns for a long-duration inflation-linked bond however, tends to be capital appreciation/depreciation derived from the move in real-yields. Real yields are the returns that a bond investor earns from interest payments adjusted for inflation, and is usually calculated by deducting the expected inflation rate from the nominal yield 1.
Source: Parameta Solutions
Although rising inflation affects the inflation ratio component of returns, it usually supports tighter monetary policy and rising nominal interest rates, thereby causing a drop or depreciation in capital value of bonds including those of inflation-linked bonds. Longer maturity bonds are usually affected more based on market’s expectation of long-term interest rates.
As evident from the chart below, the 10y real yield has gone from negative territory to positive territory, which is reflected in the performance of the iShares EUR Inflation Linked Govt Bond UCITS ETF.
Source: Bloomberg Inflation swaps come in many flavours, zero-coupon inflation swaps (ZCIS), real rate swaps, and Year-on-Year (YoY) swaps. ZCIS are considered pure inflation instruments, and are the most common form of inflation swaps given their simple structure in which exchange of cash flows (a compounded fixed payment is exchanged for a variable payment linked to a measure of cumulative accrued inflation, such as the retail prices index) occurs only at maturity.
Returns from ZCIS, are driven mainly by:
changes in inflation expectations compared with that at the time of striking the swap
inflation risk premium
ZCIS are used typically as an overlay on existing portfolios/assets, and being derivatives they offer:
capital efficiency of not having to allocate cash
flexibility in managing differing maturities/tenors
information about market implied inflation which is reflected in swap valuation
Parameta Solutions Breakeven Inflation Swap Indices (BISI) provides an indicative measure of the returns from investing in an unfunded monthly rolling ZCIS. BISI are designed to be investable indices that:
maintain “constant maturity” from one month to the next
effectively “lock-in” the returns generated from changes in inflation expectations during the month
Source: Parameta Solutions, Bloomberg As Eurozone inflation started rising during the summer of 2021, the 10y BISI performance reflected the expectation of 10y breakeven inflation which had started to increase too. The 10y BISI index started its downward trend from around Q4’2023 as expectations of inflation started to taper down.
Comparing a hypothetical total return (TR) version of the 10y BISI (reflecting returns on a notional amount from investing the index value in overnight money markets) with that of the ETF since Aug-2021, presents an interesting perspective. BISI seems to be benefit not just from the inherent behaviour of ZCIS capturing the changes in inflation expectations but also from the money market returns from higher interest rates.
Source: Parameta Solutions, Bloomberg In summary, systematic rolling investment strategy in ZCIS, such as BISI, provides a comprehensive set of building blocks for market participants to:
facilitate issuance of tracker investment products offering exposure to changes in inflation expectations, at a particular tenor or combination of tenors
allow for implementing systematic inflation strategies, such as 2y-10y inflation steepener or flattener, or even dynamically switching between the two tenors based on market or other economic signals
may find use in performance measurement or attribution of portfolio returns into inflation expectations component and real yield element
as building blocks for bespoke benchmarks for portfolios relative to mandates
In the case of a portfolio of inflation swaps, such as in the UK, that roll down to maturity over time, variants of BISI maybe created that mimic such an approach. Given the nature of such variants, vintages of indices would need to be developed for facilitating such use cases.
For more details, please email index@parametasolutions.com.
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