Inflation-linked bonds liabilities

Anyone who thought that the advent of a Eurozone inflation-linked bond would cause the French CPI linked bonds to wither on the vine has been proved mistaken. Agence France Tresor (AFT) has continued to reopen the two OATi issues, and demand for these, and the domestic inflation-linked bonds of CADES (a government-owned institution created to repay past social security liabilities), has been sufficiently strong for AFT to issue a new 10-year OAT (2.5% July 2013), in January 2003. 

This may all seem rather convoluted, so a simple example might suffice to make the point clear. Let us assume that the average bond investor expects future long-term inflation to be 2.5%, and that the average investor is inflation risk averse, so be prepared to pay a 0.25% risk premium. On this basis alone, we would expect observed break-even inflation to be 2.75%. Now let us say that the govermnent also has inflationary expectations of 2.5%, but it prefers real liabilities to nominal liabilities, and places a 0.25% yield value on that preference. It will prefer to sell inflation-linked bonds rather than nominal bonds until break-even inflation falls to 2.25%. 

In earlier chapters, we reviewed the basic features of index-linked bonds and their main uses. We also discussed the techniques used to measure the yield on these bonds. The largest investors in indexed bonds are long-dated institutions such as pension fund managers, who use them to match long-dated liabilities that are also index linked for example, a pension contract that has payments linked to the inflation index. It is common though for investors to hold a mixture of indexed and conventional bonds in their overall portfolio. 

Index-linked bonds often pay interest semiannually. Certain long-dated investors, such as fund managers whose liabilities include inflation-indexed annuities, may be interested in indexed bonds that pay on a quarterly or even monthly basis. 

Hedging pension liabilities. This is perhaps the most obvious application. Assume a life insurance company or corporate pension fund wishes to hedge its long-dated pension liabilities, which are linked to the rate of inflation. It may invest in sovereign IL bonds such as IL gilts, or in IL corporate bonds that are hedged (for credit risk purposes) with credit... 

The net cash flow leaves the pension fund receiving a stream of cash flow that are linked to inflation. The fund is therefore hedged against its liabilities. In addition, because the swap structure can be tailor-made to the pension fund s requirements, the dates of cash flows can be set up exactly as needed. This is an added advantage over investing in the IL bonds directly. 

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