Inflation-linked bonds liquidity

From market observation we know that index-linked bonds can experience considerable volatility in prices, similar to conventional bonds, and therefore, there is an element of volatility in the real yield return of these bonds. Traditional economic theory states that the level of real interest rates is cmistant however, in practice they do vary over time. In addition, there are liquidity and supply and demand factors that affect the market prices of index-linked bonds. In this chapter, we present analytical techniques that can be applied to index-linked bonds, the duration and volatility of index-linked bonds and the concept of the real interest rate term structure. Moreover, we show the valuation of inflation-linked bonds with different cash flow structures and embedded options. 

It is conceivable that the perception of inflation as irrelevant (which we would classify as money illusion), or the slightly greater complexity of these instruments, or their admittedly lower liquidity levels, might render inflation-linked bonds unpopular, but we doubt it. We have already shown how very modest mistakes in inflation estimation can still have a major cumulative impact on the real value of nominal assets... 

Inflation-linked bonds are a little less liquid than nominal bonds, but the possibility that this results in them trading cheaply—suffering an illiquidity discount —is contentious. We would propose that turnover is lower in linkers because they meet investor needs so well. They are natural buy-and-hold assets because they are worry-free core holdings. Thus, illiquidity, relative to nominals, is something investors in linkers understand and accept. It is not so much a penalty, more the price of success. 

In April 1999 the SNDO launched two new linkers, a new 30-year bond (3104, 3.5% 2028) and a new 16-year bond (3105, 3.5% 2015). These two bonds were issued with an inflation floor, meaning that the new bonds had a similar structure to United States and French inflation-indexed bonds. The format of issuing inflation linked bonds was changed, this time moving back to bid price auctions, every three months. The reason being that this type of auction was common at the international level, allowing clearer signals of the volume on offer. The primary dealers were permitted to switch linkers directly with the SNDO on a daily basis, in order to enhance the liquidity of the market. 

In essence, the real yield curve can and should be used for all the purposes for which the nominal yield curve is used. Provided that there are enough liquid index-linked bonds in the market, the real term stmcture can be estimated using standard models, and the result is more valid as a measure of market inflation expectations than any of the other methods that have been used in the past. 

Accepting that developed, liquid markets, such as that for Treasuries, are efficient, with near-perfect information available to most if not all participants, then the inflation expectation is built into the conventional Treasury yield. If the inflation premium understates what certain market participants expect, investors will start buying more of the index-linked bond in preference to the conventional bond. This activity will force the indexed yield down (or the conventional yield up). If, on the other hand, investors think that the implied inflation rate overstates expectations, they will buy more of the conventional bond. 

Indexed bonds real yields in other markets are also a factor in investors decisions. The integration of markets around the world in the past twenty years has increased global capital mobility, enabling investors to shun markets where inflation is high. Over time, therefore, expected returns should be roughly equal around the world, at least in developed and liquid markets, and so should real yields. Accordingly, index-linked bonds should have roughly similar real yields, whatever market they are traded in. 

The main drawback with this basic technique is that it requires conventional and index-linked bonds of identical maturity. Using bonds with merely similar maturities compromises the results. In addition, the bonds yields will be influenced not only by inflation expectations but by liquidity, taxation, indexation, and other considerations as well. There is also no equivalent benchmark (or on-the-run) indexed security. 

Certain countries have markets in bonds whose coupon or final redemption payment, or both, are linked to their consumer price indexes. Generally, the most liquid markets in these inflation-indexed, or index-linked, debt instruments are the ones for government issues. Investors experiences with the bonds differ, since the securities were introduced at different times in different markets and so are designed differently. In some markets, for instance, only the coupon payment, and not the redemption value, is index-linked. This makes comparisons in terms of factors such as yield difficult and has in the past hindered arbitrageurs seeking to exploit real yield differences. This chapter highlights the basic concepts behind indexed bonds and how their structures may differ from market to market. 

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