An Investors Guide

to Inflation-Linked
Bonds

An investors guide to inflation-linked bonds

This communication is for investment professionals
only and should not be distributed to or relied upon
by retail clients

Contents
1 About Standard Life Investments
2 Some Key Concepts
3 Who Issues Inflation-Linked Bonds?
4 Who Invests in Inflation-Linked Bonds?
5 The Benefits of Inflation-Linked Investing
6 A Wide Opportunity Set
8 Managing Currency Risk in a Global Inflation Portfolio
9 A Brief History of Inflation-Linked Markets
11 The Role of Inflation Swaps
12 Key Global Inflation Indices
13 Contact Details

An investors guide to inflation-linked bonds

About Standard Life Investments

Standard Life Investments is a premier asset manager with an expanding

global reach. Our wide range of investment solutions is backed by our
distinctive Focus on Change investment philosophy, disciplined risk
management and shared commitment to a culture of investment excellence.
As active managers, we place significant
emphasis on rigorous research and a strong
collaborative ethos. We constantly think
ahead and strive to anticipate change before it
happens, ensuring that our clients can look to
the future with confidence.
As at 31 December 2011, Standard Life
Investments managed 154.9 billion on
behalf of clients worldwide. Our investment
capabilities span equities, fixed income, real
estate, private equity, multi-asset solutions,
fund-of-funds and absolute return strategies.
Headquartered in Edinburgh, Standard Life
Investments employs more than 1,000 talented
professionals. We maintain offices in a number
of locations around the world including Boston,
Hong Kong, London, Beijing, Montreal, Sydney,
Dublin, Paris and Seoul. In addition, we have close
relationships with leading domestic players in

Asia, including HDFC Asset Management in India

and Sumitomo Mitsui Trust Bank in Japan.
Our parent, Standard Life plc, was established
in 1825. A leading provider of long-term savings
and investments, Standard Life floated on
the London Stock Exchange in 2006 and is
now a FTSE 100-listed company. Standard
Life Investments was launched as a separate
company in 1998 and has quickly established
a reputation for innovation in pursuit of our
clients investment objectives.
Our investors rank among some of the
worlds most sophisticated and high-profile
institutions. They include corporate pension
plans, banks, mutual funds, insurance
companies, fund-of-fund managers,
endowments, foundations, charities, official
institutions, sovereign wealth funds and
government authorities.

An investors guide to inflation-linked bonds

Some Key Concepts

The features of an inflation-linked bond

An inflation-linked bond is similar to a nominal
bond such as a Treasury bond. The only difference
is that both its principal (the final payment at
maturity) and its coupon (the interest rate paid
during the life of the bond) are linked to an
inflation index. This means that the investor
receives the real face value of the bond at
maturity, and the real value of the interest rate
in the meantime.
For example, if the annual coupon of a
nominal bond was 5% and the underlying
principal of this bond was 100, the annual
coupon payment would be 5. In the case
of an inflation-linked bond, if the inflation
index increased by 75% over the life of
the bond, the principal of the bond would
increase to 100 x 175% = 175. The
nominal coupon rate would rise in line with
the price index over the life of the bond, and
in this instance would be 8.75% (but still 5%
in real terms) at maturity.

Real yields
Instead of focusing on nominal yields, investors
in inflation-linked bonds are interested in real
yields, which measure a bonds yield adjusted
for inflation. This measure is important because
inflation erodes the real value of investment
returns on nominal bonds, and consequently
reduces an investors spending power in the
future. It is also important to investors whose
liabilities are impacted by inflation, as investors
will seek to retain real spending power for
the future.
In fundamental economic terms, real yields can
be interpreted as the price of economic capital
for example, the price that businesses have
to pay to invest in new plant and machinery. In
boom times, this price rises with the demand
for that capital, and therefore so do real yields.
Conversely, in times of weakness, real yields
fall as demand for capital falls.

Nominal yields

The yield on a nominal bond yield can be

deconstructed using what is known as the
Fisher equation. This breaks down nominal

An investors guide to inflation-linked bonds

yields into three components: inflation

expectations, a required real yield that
investors demand over and above those
inflation expectations, and a risk premium.
This last factor, which represents the price
investors are prepared to pay for a guaranteed
real return, is notoriously difficult to calculate,
and many an academic has failed to quantify
it. For this reason, the market convention
is to include risk premium within inflation
expectations, resulting in the following
simplified formula:

n=r+i
Where:
n =
yield on a nominal bond
r = real yield on an IL bond
of the same term maturity
i =
inflation expectations
This equation results in one of the most
important concepts for investors. The inflation
expectations element of the formula represents
the expected average level of growth in the
price level over the life of a nominal bond and
an inflation-linked bond of similar maturities. By
extension, if the market is correct about these
expectations, then in order for the equation to
remain in equilibrium, the overall returns on the
two bonds must be identical. This is known as
the breakeven rate. If inflation is higher than
what is priced in over the life of the bonds, the
inflation-linked bond will give a higher return; if
lower, the nominal bond will perform better.
So investors who wish to take a view on the
path of inflation have a choice. If they believe
that inflation will be higher than the level priced
in by the market, they will sell nominal bonds
and buy inflation-linked. If lower, they will do
the opposite. If of course the market is right,
the investors will breakeven.
However, this is not just a hold-to-maturity
strategy, as a breakeven rate priced by the
market represents the expected average
rate of inflation over the life of the bonds.
Inflation expectations vary with economic
conditions, and so by varying the weightings
of nominal and inflation-linked bonds in
the portfolio, investors can take views on
movements in those expectations.

Who Issues
Inflation-Linked Bonds?
The primary issuers of inflation-linked bonds
are governments. All of the G7 governments,
and many others, now use the asset class as
part of their borrowing program. The reasons
behind this are manifold, but it is done at
least in part to cheapen the cost of funding.
Governments expect to save the risk premium,
by guaranteeing investors a real return.
Investors are willing to pay more for this surety.
Issuing inflation-linked bonds can be shown
to smooth the cashflows of a government.
A good deal of governments incomes are at
least partly inflation-linked. Sales and value
added taxes along with excise duties are prime
examples. By matching the mix of income
and payments, a government can reduce
the volatility of its cashflows and, in theory
at least, needs to adjust its tax rates less
frequently.
Inflation-linked bonds provide informational
advantages to governments and central banks
by demonstrating a market-driven, observable,
measure of inflation expectations. On occasion,
this can be distorted by institutional factors,
but implied inflation expectations are a useful
tool for policy makers.
In some instances, issuing in the inflationlinked market has been used as a
demonstration of a governments inflationfighting credentials. For example, the UK
launched its inflation-linked market in the

early 1980s at a time of high inflation and

by taking on the inflation risk of its debt, it
was demonstrating its determination to bring
inflation under control. Many governments, for
example some in South America, have found
that when their inflation rates were persistently
high, inflation-linked bonds were the only
bonds that investors would buy.
Issuance of inflation-linked bonds can also
be seen as a means of reaching out to the
widest range of investors possible, while also
diversifying the risk of a government. In many
ways, a government can be seen as a fund
manager with the assets and liabilities column
headings swapped over. Diversifying assets is
every bit as important as diversifying liabilities.
Non-government issuers are fairly rare outside
the UK, and are dominated by semi-government
and agency issuers such as KfW, EIB and New
South Wales Treasury Corporation. In the UK,
a number of utility companies, whose pricing
structures are statutorily linked to the Retail
Price Index, have issued inflation-linked bonds.
There are also a number of Private Finance
Initiative bonds (PFI is a scheme to encourage
government sponsored infrastructure spend
without affecting the governments balance
sheet), which were used to finance the building
of schools and hospitals, and similarly had
inflation-linked cashflows. Outside the UK,
inflation markets are almost exclusively
government and semi-government issued.

An investors guide to inflation-linked bonds

Who Invests in
Inflation-Linked Bonds?

Typical investor profile

Inflation-linked bonds appeal to a wide and
growing range of investors. Clearly, the ability
to match inflation-linked liabilities is the prime
reason to invest. If investors real liabilities are
concrete, the only way to guarantee a cashflow
in real terms at that point is to buy an inflationlinked bond that matures at the same time as
the liability. Plenty of other real assets exist,
such as equities, property and commodities,
but they do not constitute an inflation hedge.
They are far more volatile than the price level,
and may actually deliver a loss in real terms at
the appointed time. A mixture of real assets
will usually be a more efficient portfolio than a
single asset, and inflation-linked bonds tend to
be poorly correlated with riskier real assets, so
there is considerable diversification advantage
to be had from adding inflation-linked bonds to
the portfolio.
Investors with a portfolio of fixed real terms
liabilities may buy a matching portfolio of
inflation-linked bonds. The portfolio can be
designed to closely match the liability profile.
Many more investors however opt for a less
rigid match, but look at the appropriateness

An investors guide to inflation-linked bonds

of the mix of their assets relative to liabilities.

This tends to result in investments in actively
managed, benchmark-driven portfolios of
inflation-linked bonds.
The most prominent among these investors
are pension funds. They, by definition, have an
extensive book of real liabilities, which they
must meet at the appropriate time. An immature
pension fund, where most of the liabilities are a
long way in the future, can afford to take a riskier
view, holding a more volatile range of real assets.
As the fund matures, the risk appetite of the fund
falls, and the need for closer liability matching
grows. This applies both to an individuals
pension investment fund, and to company or
institutional wholesale funds. So as a fund
matures, weightings in equities and property
tend to fall in favour of inflation-linked exposure.
Charities, endowments and foundations are
also major investors in inflation-linked assets,
looking to preserve capital without undue
volatility. These investors also frequently have
inflation-linked payment schedules to their
beneficiaries, which makes inflation-linked
investments all the more suitable.

The Benefits of
Inflation-Linked Investing
In addition to the liability matching benefits we
have just discussed, inflation-linked bonds play
a much wider role in both the bond portfolio,
and the total portfolio of assets. Bondholders
who expect inflation expectations to rise
should increase their holdings of inflationlinked bonds, as these will outperform nominal
bonds if this occurs. Inflation-linked bonds
are also less volatile than nominal bonds, as
they respond to movements in real yields, not
nominal yields. This results in a smoothing of
returns to investors.

More importantly though, inflation-linked

portfolios, and particularly global ones, offer
significant levels of diversification within the bond
portfolio, as they have a relatively low correlation
with other bond asset classes. Within the wider
portfolio, those correlations are even lower,
meaning that a global inflation-linked portfolio is
an excellent diversifier, improving risk and return
characteristics of the overall portfolio and pushing
the investor closer to his or her efficient frontier.

An investors guide to inflation-linked bonds

A Wide Opportunity Set

While the US remains the largest issuer of

inflation-linked bonds, investing in global
inflation-linked bonds offers a broader
opportunity set than domestic portfolios, in
addition to giving access to the global liquidity
pool. The global market extends maturities
available for US investors from 30 to 45 years.
The chart below is a distribution by size and
maturity of bonds in the Barclays Global
Inflation-Linked Index, showing the depth of the
opportunity set available. Liquidity is generally
good across the major inflation-linked issuers.

Access to derivatives, while not required, widens

the opportunity set yet further.
In addition to the reduction in risk brought about
by reducing exposure to unexpected changes
in price levels by investing in an inflation-linked
portfolio, moving from a domestic portfolio to
a global portfolio reduces the risk further still,
as no one country will determine the success or
failure of your investment portfolio. In addition,
a global portfolio will expand the opportunity
set beyond the purely domestic market.

Barclays Global Inflation-Linked Index - Distribution by Size and Maturity

50000
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
April-12
Austrailia

September-17
Canada

March-23
Denmark

September-28
France

UK

February-34
Italy

Source Barclays Capital, Barclays Global Inflation-Linked Index as at 08/02/2012.

An investors guide to inflation-linked bonds

August-39
Japan

Sweden

February-45
US

July-50

Reducing risks
The chart below suggests very strongly that a portfolio of hedged global inflation-linked bonds
is much more efficient than a simple domestic one, displaying significantly better risk-return
characteristics. Similar results are generated against other bond asset classes, and even greater
diversification benefits are shown against asset classes in the wider portfolio.

Efficient Frontier: World Govt Inflation-Linked All Maturities hedged vs FTSE

British Govt Index-Linked All Maturities
7.6
7.5

100% World Govt Inflation-Linked All

Maturities Hedge
Best Risk Adjusted Return

Return%

7.4
7.3
7.2
7.1
7.0

100% FTSE British Govt

Index-Linked All Maturities

6.9
6.8
5.0

5.2

5.4

5.6

5.8

6.0

6.2

6.4

6.6

Risk%
Source: Datastream and Barclays Capital: 31/12/1999 - 31/01/2012

Active versus passive investment

We believe that the inflation-linked bond
markets are inefficient, and this creates an
opportunity for active investment managers to
outperform those that adopt a passive strategy.
Because inflation-linked bonds represent a
relatively small proportion of the global bond
market, there is relatively limited research
undertaken. Markets are localised, and different
markets are affected by different drivers.
Adopting a passive strategy commits investors
to abide by whatever the rules of the passive
benchmark are, however bad. For example,
an issuing country may underperform very

substantially before being ejected from a

benchmark index, damaging returns to passive
investors. Active investors can anticipate such
changes and create outperformance. This was
the case when Greek inflation-linked bonds
were ejected from the benchmark indices at
the end of 2009. Passive investors will have
been forced to sell at the end of the year
when Greece dropped out of the benchmark.
Active investors had the ability to reduce their
exposure well in advance of this. Passive
investing ensures that investors will fall into
every pitfall along the way, whereas active
investing allows the manager to help investors
to avoid them.

An investors guide to inflation-linked bonds

Managing Currency Risk in a

Global Inflation Portfolio
Holding a global portfolio of course introduces
exposure to the inflation rates of other
countries, and therefore a mismatch in returns.
However, in a diversified global portfolio, so
long as the currency exposure is hedged back
to the domestic currency, the mismatch should
be small over time.
This relies on the concept that countries with
higher inflation tend to have higher interest
rates. This will mean that over the cycle, the
carry on the foreign exchange hedge will offset
the inflation mismatch.

An investors guide to inflation-linked bonds

For example, an investor in a higher inflation,

higher interest rate economy buys inflation-linked
bonds in a lower inflation, lower interest rate
economy. The bonds will provide insufficient uplift
to match his domestic inflation, but the interest
rate differential will mean there is a positive carry
on the foreign exchange hedge, and these two
should, over the medium term, net out.
These relationships are not perfect and do not
work instantaneously, but a well diversified,
hedged global portfolio of inflation-linked
bonds should, over the medium term, be an
effective domestic inflation-linked asset.

A Brief History of
Inflation-Linked Markets
A global market in government inflation-linked
bonds has only really existed since around
the turn of the millennium. The UK was the
first major issuer in 1981, and for some time
it was a small corner of the world markets,
present in just the UK, Canada and Australia.
When the US launched its Treasury Inflation
Protected Securities (TIPS) program in 1997,
the global market began to emerge. Euro-zone
issuers followed, with France issuing bonds
indexed both to French inflation (OATi) and
Euro-zone inflation (OATei), and Italy, Greece
and eventually Germany following in Eurozone-linked bonds. Japan completed the list
of G7 issuers in 2004, and Sweden is also a

large enough issuer to gain entry to market

benchmark indices.
The chart below shows the growth in the
market value over time, showing that recent
years have seen a massive increase in both
supply and demand.
The TIPS market has, unsurprisingly, surpassed
all others in terms of size, representing 34%
of the Barclays Global Inflation-Linked Index.
The Euro-zone has grown to 18% of bonds
outstanding. Australia returned to issuance
in the autumn of 2009, with a A$4bn issue
(sources: Barclays Capital; Australian Office of
Financial Management).

Barclays Global Index Inflation-Linked Bonds Market Value ($bn)

2000
1800
1600
1400
1200
$bn 1000
800
600
400
200
0
1996
US

1997
UK

1998
Sweden

1999
Japan

2000
Italy

2001

2002

Germany

2003
France

2004

2005

Canada

2006

2007

2008

2009

2010

201 1

Australia

Source: Barclays Capital. Data as of December 31, 2011

An investors guide to inflation-linked bonds

is the prime example of this, and represents

a large proportion of the emerging market
inflation-linked index.

Other issuers
Many other countries issue inflation-linked
bonds, but are too small a size or too poor
a credit rating to enter mainstream indices.
Many countries at one stage could only issue
in inflation-linked bonds, as investors would
not buy nominal assets of countries with weak
currencies and persistent high inflation. Brazil

Brazil has a long history in government

inflation-linked bonds, its first issue dating
back to 1964. It is the largest emerging market
issuer with over $130 billion market value.

EM Inflation-Linked Bonds Market Value ($bn)

600
500
400
$bn 300
200
100
0
1996

1998

Israel

Turkey

2000
Poland

2002

Mexico

2004

South Korea

2006

Colombia

Brazil

2008
Argentina

2010

Chile

South Africa

Source: Barclays Capital: 12/31/1996 - 12/31/2011

Inflation-Linked Bonds Outstanding by Market Value ($bn)

800
700
600
500
$bn 400
300
200

Source: Barclays Capital. Data as of December 31, 2011

10

An investors guide to inflation-linked bonds

Israel

Turkey

Poland

Mexico

South Korea

Colombia

Brazil

Argentina

Chile

South Africa

US

UK

Sweden

Japan

Italy

Germany

France

Canada

Australia

100

The Role of Inflation Swaps

As the size and sophistication of the global inflation market has expanded, a range of inflation
derivative products has arrived to broaden the opportunity set further. The market for inflation
swaps offers investors an alternative means of expressing their views on inflation.
In each region, the inflation swap market uses the index to which domestic bond markets are linked.
The most common structure of inflation swap traded is a zero coupon swap, where there is just one
cashflow in each direction at maturity. In the example below, Party B pays a fixed amount, agreed at
inception, and receives an amount linked to the growth in the relevant inflation index over the life of
the swap. Therefore, if the price level rises by more than the fixed amount, party B makes a profit on
the swap. The value of the swap at any given point in its life is determined by movements in inflation
expectations since the inception of the trade.

Role of Inflation Swaps

Inflation
Party A

Party B
Fixed Rate

There are active inflation swap markets in the

UK, US, Euro-zone, France, Australia and Japan.
There are also less developed markets in
Sweden and Canada but activity is very light.
The inflation swap market and inflation-linked
bond markets often interact via asset swap
activity (whereby an investor can pay inflationlinked bond cashflows to a counterparty in
exchange for LIBOR flows). The more active
swap markets also have their own liquidity.
Supply tends to come from corporate bond
issuance, structured medium-term notes or
retail savings products linked to inflation.
Demand comes from pension funds (especially
in the UK and a growing theme in Europe), real
money and leveraged investors.

The zero coupon nature of inflation swaps

makes it an efficient way of implementing a
view or hedging an exposure on a particular
part of the curve without worrying about any
cashflows prior to maturity that can be an issue
when using bonds.
Inflation swaps are now used by a wide variety of
investors, for matching and hedging purposes,
as well as in conjunction with bond markets to
create more efficient portfolios. It should be noted
though that a long term inflation swap does not
guarantee a cashflow; if ones swap counterparty
ceases to exist, so does the swap. Swaps may be
collateralized (typically daily) such that the current
market value of a swap is protected, but the actual
pay-out should not be seen as equivalent in risk to
a government bond.

An investors guide to inflation-linked bonds

11

Key Global Inflation Indices

Major issuers and their corresponding indices are shown in the table below:

Key global inflation indices

Country

Issue

Issuer

Inflation index

United States

Treasury InflationProtected Securities

(TIPS)

US Treasury

US Consumer Price
Index (NSA)

United Kingdom

Inflation-linked Gilt

UK Debt Management
Office

Retail Price Index

Japan

JGBi

Ministry of Finance

Japan CPI

Germany

Bund index and BO

index

Bundesrepublik
Deutschland
Finanzagentur

EU HICP ex Tobacco

Agence France Tresor

France CPI ex-tobacco

(OATi), EU HICP (OATei)

France

12

OATi and OATei

Canada

Real Return Bond

Bank of Canada

Canada All-items CPI

Australia

Capital Indexed Bonds

Department of the
Treasury (Australia)

ACPI

Sweden

Index-linked treasury
bonds

Swedish National Debt

Office

Swedish CPI

Italy

BTPi

Department of the
Treasury

EU HICP ex Tobacco

An investors guide to inflation-linked bonds

Contact Details

For further information, please speak to your usual contact at Standard Life Investments,
or visit our website:

Visit us online

standardlifeinvestments.com

An investors guide to inflation-linked bonds

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An investors guide to

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inflation-linked
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