Inflation-linked bonds market

Last, but not least, one sector that is increasingly gaining importance, not only in terms of amounts issued but also in investors interest, is the inflation-linked bond market. Up to this moment the French Tre-sor has been the main issuer of these bonds, although some other treasuries have already issued small amounts in these type of bonds (Greece) or have expressed their desire to do it in the future (Italy). 

We have sketched out a couple of reasons why governments issue index-linked bonds already. We also said how the removal of inflation risk is valuable for the borrower, as it is for the investor, and earlier we described how in some countries rampant inflation resulted in a complete loss of investor confidence in nominal government debt, requiring the creation of an inflation-linked bond market out of necessity. However, there are other arguments why governments should issue linkers, and the reasons already given need to be added to, expanded upon and broken down into different subarguments. 

The Fisher equation, which predated the existence of inflation-linked bond markets, states that a nominal bond yield is made up of three components—inflationary expectations, a required real yield that investors demand over and above those inflationary expectations, and a risk premium. The risk premium reflects the assumption that investors want additional compensation for accepting undesirable inflation risk when holding (therefore suboptimal) nominal bonds. 

Inflation-indexed derivatives, also known as inflation-linked derivatives or inflation derivatives, have become widely traded instruments in the capital markets in a relatively short space of time. They are traded generally by the same desks in investment banks that trade inflation-linked sovereign bonds, which use these instruments for hedging as well as to meet the requirements of clients such as hedge funds, pension funds, and corporates. They are a natural development of the inflation-linked bond market. 

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. 

To obtain the price of an inflation-linked bond, it is necessary to determine the value of coupon payments and principal repayment. Inflation-linked bonds can be structured with a different cash flow indexation. As noted above, duration, tax treatment and reinvestment risk, are the main factors that affect the instrument design. For instance, index-aimuity bmids that give to the investor a fixed annuity payment and a variable element to compensate the inflation have the shortest duration and the highest reinvestment risk of aU inflation-linked bonds. Conversely, inflation-linked zero-coupon bonds have the highest duration of all inflation-linked bonds and do not have reinvestment risk. In addition, also the tax treatment affects the cash flow structure. In some bond markets, the inflation adjustment on the principal is treated as current income for tax purpose, while in other markets it is not. 

In other words, the option is valuable when the principal is lower than 100. When the inflation rate drops and the economy is in a hypothetical deflation scenario, the option is in the money. This increases the value of an inflation-linked bond. Note that the probability of a deflation scenario depends on the market sentiment and implied inflation rate between conventional and... 

EXHIBIT 8.1 Market Value Composition of the Barclays Capital Global Inflation-Linked Bond Index ( billion)... 

In 1995 the SNDO launched the second inflation-linked bond, another zero but with a shorter maturity of 10 years (No. 3002, 0% 2004). At this time the SNDO decided to replace the common price anc-tions with multiple price auctions. Moreover, the SNDO opened a noncompetitive facility for small volumes in the auctions, so that small investors could enter the market. In February 1996 the SNDO launched two new bonds a 5-year zero-coupon bond (3003, 0% 2001) and a 12-year coupon bond (3101, 4% 2008). In June 1996 the 24-year coupon bond (3102, 4% 2020) was launched. The market continued to grow rapidly in 1997 and 1998. 

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. 

So we have formally introduced the notion of break-even inflation, a term at the heart of inflation-linked bond analysis and trading. In principle it is the rate of inflation that will equate the returns on an inflation-linked bond and a comparator nominal bond issue of the same term. In theory, calculating it by simply subtracting a real yield from a nominal yield is a crude form of a properly compounded calculation, particularly when bond market conventions are semi-annual and what you should want is an annual measure of inflation. 

Exhibit 8.11 charts the dividend yield gap for the European markets with inflation-linked bond sectors. 

Inflation-linked derivative instruments are now widely traded in the capital markets divisions of investment banks that trade the sovereign inflation-linked bonds. Many smaller banks with regional dominance are also building up their trading capabilities as they rise to meet the increasing demand from their client base for inflation-linked products. 

Bonds that have part or all of their cash flows linked to an inflation index form an important segment of several government bond markets. In the United Kingdom, the first index-linked bonds were issued in 1981 and at the end of 2012 they accounted for approximately 25% of outstanding nominal value in the gilt market. Index-linked bonds were also introduced in the United States Treasury market but are more established in Australia, Canada,... 

Index-linked or inflatiOTi-indexed bonds present additional issues in their analysis, due to the nature of their cash flows. Measuring the retimi on index-linked bonds is less straightforward than with conventional bonds, and in certain cases there are peculiar market structures that must be taken into accotmt as well. For example, in the United States market for index-linked treasuries (known as TIPS from Treasury Inflation-Indexed Securities) there is no significant lag between the inflation link and the cash flow payment date. In the United Kingdom, there is an 8-month lag between the inflation adjustment of the cash flow and the cash flow payment date itself, while in New Zealand there is a 3-month lag. The existence of a lag means that inflation protection is not available in the lag period, and that the return in this period is exposed to inflation risk it also must be taken into account when analysing the bond. 

One final point regarding duration is that it is possible to calculate a tax-adjusted duration for an index-linked bond in markets where there is a different tax treatment to indexed bonds compared to conventional bonds. In the United States market, the returns on indexed and conventional bonds are taxed in essentially the same manner, so that in similar fashion to Treasury strips, the inflation adjustment to the indexed bond s principal is taxable as it occurs, and not only on the maturity date. Therefore, in the US-indexed bonds do not offer protection against any impact of after-tax effects of high inflation. That is, Tips real yields reflect a premium for only pretax inflation risk. In the United Kingdom market however, index-linked gilts receive preferential tax treatment, so their yields... 

Using the prices of index-linked bonds, it is possible to estimate a term structure of real interest rates. The estimation of such a curve provides a real interest counterpart to the nominal term structure that was discussed in the previous chapters. More important it enables us to derive a real forward rate curve. This enables the real yield curve to be used as a somce of information on the market s view of expected future inflation. In the United Kingdom market, there are two factors that present problems for the estimation of the real term structure the first is the 8-month lag between the indexation uplift and the cash flow date, and the second is the fact that there are fewer index-linked bonds in issue, compared to the number of conventional bonds. The indexation lag means that in the absence of a measure of expected inflation, real bond yields are dependent to some extent on the assumed rate of future inflatiOTi. The second factor presents practical problems in curve estimation in December 1999 there were only 11 index-linked gilts in existence, and this is not sufficient for most models. Neither of these factors presents an insurmountable problem however, and it is stiU possible to estimate a real term structure. 

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. 

An index-linked bond has its coupon or maturity value or sometimes both linked to a specific index. When governments issue index-linked bonds, the cash flows are linked to a price index such as consumer or commodity prices. Corporations have also issued index-linked bonds that are connected to either an inflation index or a stock market index. For example, Kredit Fuer Wiederaufbau, a special purpose bank in Denmark, issued a floating-rate note in March 2003 whose coupon rate will be linked to the Eurozone CPI (excluding tobacco) beginning in September 2004. Inflation-indexed bonds are detailed in Chapter 8. 

The objectives of this chapter are to discuss the benefits of the inflation-linked asset class to both issuers and investors, to provide brief histories and salient characteristics of the different European inflation-linked markets (both bonds and derivatives), and to introduce key analytical and trading concepts. 

These derivatives provide additional sources and destinations for inflation-linked flows, lower the barrier to entry, and bring in an expanded universe of market participants. This has, over time, enhanced and made more efficient the underlying bond market. 

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