Inflation-linked bonds trading

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. 

We have already described the notion of bond trading in three dimensions, thanks to the availability of linkers. Perhaps the most important aspect of this 3D trading is the ability to implement a view with much greater precision. Often, when trades are done in nominals, they really reflect a view on inflation, bnt because nominal yields do not just represent inflationary expectations, this is an imprecise enactment of that view. With inflation-linked bonds, investors can express a much purer inflation expectation. 

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. 

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. 

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. 

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. 

In the United States, Canada, and New Zealand, indexed bonds can be stripped, allowing coupon and principal cash flows to be traded separately. This obviates the need for specific issues of zero-coupon indexed securities, since the market can create products such as deferred-payment indexed bonds in response to specific investor demand. In markets allowing stripping of indexed government bonds, a strip is simply a single cash flow with an inflation adjustment. An exception to this is in New Zealand, where the cash flows are separated into three components the principal, the principal inflation adjustment, and the inflation-linked coupons—the latter being an indexed annuity. 

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. 

Index-linked gilts, like all other linkers covered in this chapter, are known as capital indexed bonds, where the income and principal are adjusted for changes in a consumer price index, subject to a lag. In the United Kingdom, the index is the RPI and the lag is eight months. The market trades on a clean price basis, with the quoted price a cash price (not a real price), including inflation accretion. 

An important aspect of trading these bonds is using expectations of future monthly changes in linking indices, provided by economists, to calculate expected forward real yields and expected forward break-even inflation. Making assumptions about future price index levels allows these forward aggregates to be calculated in the same way that forward nominal bond prices and yields are worked out. 

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