GLOBAL INVESTOR 2.07 Basics — 18 Photo: Justin Guariglia/Getty Images Roadway, Guangzhou, China
GLOBAL INVESTOR 2.07 Basics — 19 Inßation-linked bonds as an asset class Inflation-linked bonds are primarily issued by governments. The bonds offer investors a direct hedge against inflation, as well as a real yield. Historically, inflation-linked bonds have exhibited a negative correlation to equities. Their solid risk/ return ratio and low correlation to other asset classes make them a valuable alternative investment asset in both strategic and tactical asset allocation. Dr. Jeremy J. Field, Credit Analyst, Dr. Karsten Linowsky, Fixed Income Strategist Paul Volcker, the chairman of the US Federal Reserve Bank from 1979 to 1987, is generally credited with bringing the US economy out of the stagflation crisis (stagflation is a period of inflation, low growth) that followed the two oil price shocks of the 1970s. The US consumer price inflation peaked in 1980 at 13.5% (Figure 1). The Federal Funds rate peaked at 20% in June 1981 (Figure 2), and the yield on the 10-year US Treasury Note (US T-Note) rose to around 16%. This tight monetary policy had the desired result of lowering inflation, which came down dramatically to 3.2% in 1983. Following the traumatic inflation experience of 1979 to 1981, the UK was the first government to start offering inflation-linked bonds in 1981 in response to demand from institutional investors. Other industrialized countries have followed suit: Australia (1985), Canada (1991), Sweden (1994), USA (1997), France (1998), Italy (2003), Japan (2004) and Germany (2006). Figure 3 shows the development of the consumer price in dices of selected industrialized countries. Table 1 shows the index details of Barclays’ world inflation-linked bond index. While governments are by far the largest issuers of inflationlinked bonds, there are other issuers, such as the French government agency CADES, as well as some utilities and banks. However the non-government issues generally suffer from a lack of liquidity in secondary markets. Total return performance of ILBs as an asset class Figure 1 US CPI and annual inflation rate US headline consumer price index (CPI) normalized to 100 in 1983 and inflation rate from 1913 to present. Source: Credit Suisse, Fed Res Bk Minneapolis CPI 250 200 150 100 50 0 Figure 2 1914 1926 1938 1950 1962 1974 1986 1998 Fed Funds and 10-year Treasury yield The US Federal Reserve Bank target rate and the US Treasury Note 10-year yield. Source: Credit Suisse, Bloomberg % 20 15 Cumulated inflation Inflation rate (r.h.s.) Inflation rate % 20 15 10 5 0 –5 –10 –15 Changes in inflation expectations and real yields, together with changes in risk and liquidity premiums, are the main factors that drive ILB total returns versus the total returns of other asset classes, as well as the correlation of returns. Table 2 details the average annual total returns for USD assets from 1997 to the present. The excess return is the return over Treasury Bills (cash). The standard deviation indicates the price volatility of the asset class. Of the asset classes analyzed, the highest total return was achieved by real estate, 15.9%, with an excess return per unit of risk (Sharpe ratio) of 0.83. Hedge funds also performed well with 9.78% and a Sharpe ratio of 0.80. Emerging market bonds were the second-best-performing asset class with an average return of 10.5%, but with a less satisfactory risk/return than real estate, hedge funds and ILBs. With an average return of 8.05%, equities outperformed US government ILBs (TIPS, Treasury Inflation Protected Securities) but 10 5 0 01/71 01/74 01/77 01/80 01/83 01/86 01/89 01/92 01/95 01/98 01/01 Fed fund target 10-year benchmark rate 01/04 01/07