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correlation between EUR and USD government inflation-linked
bonds and other asset classes. The lower the correlation coefficient
(R 2 ), the higher the diversification value, and a value of 1.00
indicates perfect correlation, while a value of 0.00 indicates that
two asset classes exhibit no correlation. For example, the correlation
between EUR linkers and EUR (nominal) government bonds
is 0.58. The correlation between USD linkers and USD equities
is 0.02, etc.
Real bond yields are comparatively stable, leading to less
price and yield volatility for inflation-linked bonds than nominal
government bonds with a similar maturity. The attractiveness of a
financial asset is usually measured in terms of the balance
between expected return and volatility (risk). In this respect, inflation-linked
bonds are attractive in a portfolio context because of
their low volatility. Barclays Capital has analyzed the so-called
efficient portfolio frontier for a mix of US dollar-denominated
assets: TIPS, the S&P 500 equity index, and US Treasury notes
and bills. The efficient portfolio frontier is the portfolio weighting
of these four financial assets that gives the minimum standard
deviation of return for a range of return outcomes (Figure 2) . The
maximum return of 8.25% for the lowest risk is achieved with a
portfolio comprising 89% TIPS and 11% of the S&P 500 index.
The middle curve in Figure 2 is the efficient frontier when the
TIPS weighting is constrained at 20% . However, both curves indicate
how the risk-adjusted return can be improved by adding
inflation-linked bonds to the asset allocation. The EUR inflationlinked
bond market is newer and smaller than the TIPS market,
but similar conclusions can be drawn regarding the positive
effects of including inflation-linked bonds.
Conclusions and recommendations
Inflation-linked bonds can be considered as an asset class in their
own right and offer valuable diversification in an asset portfolio.
The demand for inflation-linked bonds comes mainly from pension
funds. The total market in government linkers is large and transparent,
with relatively good liquidity, except for very large institutional
investors. We expect the inflation-linked market in euros to
be the object of renewed interest when Germany starts issuing
such bonds in 2005 . Recent macroeconomic developments have
heightened uncertainty about the prospects for inflation and make
a renewed look at inflation-linked bonds worthwhile in our opinion.
These bonds provide a certain protection against future inflation
risk, contingent on how well investors’ inflation risk is aligned
with the CPI, to which a particular bond is linked. The inflation
adjustment applied to the coupon is based on the time-lagged
inflation rate of the linked CPI. The CPIs used for the inflation
linking are generally not seasonally adjusted, which adds to transparency.
In general, inflation-linked bonds outperform nominals as
interest rates rise because they benefit from increasing inflationrate
expectations. |
Index
01/96
GLOBAL INVESTOR 1.05 Inflation linked bonds — 31
Figure 1
Consumer price indices (renormalized)
for France, UK and USA
Source: Bloomberg
130
120
110
100
90
Return in %
01/97
01/98
01/99
01/00
01/01
01/02
01/03
France CPI USA CPI UK CPI
Figure 2
Efficient investment frontier in US dollars
Source: Barclays Capital
8.5
8
7.5
7
6.5
6
5.5
5
4.5
4
3.5
01/04
Volatility % 0 1 2 3 4 5 6
No TIPS
Max. 20% TIPS
TIPS, Treasurys, S&P,
T-bills, unconstrained