ECOM074 Bond Market Strategies

6. Inflation-indexed bonds

Darren Cullen
d.cullen@qmul.ac.uk
Contents

1. A breakeven inflation strategy that failed

2. Inflation reduces the purchasing power of money
3. Real yield calculation using CPI inflation
4. Inflation-indexed bonds
5. Two-step bond price calculation process
6. Breakeven inflation
7. Breakeven inflation bond trading strategies
Darren Cullen ECOM074 2
 A breakeven inflation trading strategy that failed
PART 1

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Goldman drops 5 of 6 top trades for 2016
Bloomberg Business, February 9 2016

1. Goldman’s 4. US 10-year
inflation bet breakeven
gone wrong inflation rate
target 2.0%
2. US 10-year
breakeven 3. US 10-year
inflation rate breakeven
starting at inflation rate
1.6% sinks to
in November 1.2%
2015 in February
2016
Darren Cullen ECOM074 4
 Inflation reduces the purchasing-power of money
PART 2

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Inflation defined

A general

increase in prices
and fall in the

purchasing value of money

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Chart 1 US consumer price index
US Bureau of Labor Statistics BLS, 1950 = 1.0

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 Chart 2 Purchasing value of money
$100 deflated using US consumer price index CPI

Inflation
has significantly
reduced the
purchasing power of
money
in the US over the
long term

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Chart 3 US CPI inflation 1950-2012
CPI-U annual inflation rate produce by Bureau of Labor Statistics BLS

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Table 1 CPI inflation for selected countries in 2017
http://stats.oecd.org/Index.aspx?DataSetCode=MEI_PRICES

Country CPI inflation

year-on-year
percent change

US 2.1%
Japan 0.5%
Euro Area 1.5%
UK 2.7%

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Example 1 Inflation reduces purchasing power of fixed cash flows
Assuming CPI inflation averaging 2.25% over the next 30 years

1. Buy a 3.25% 30-year US Treasury bond

2. Price = Par = $100
3. Investment of $100 million
4. Semi-annual coupon payments
5. Coupon interest payments = 0.5 x 0.0325 x $100 million
6. Coupon interest payments x 60 = $1.625 million each
7. Principal payment = $100 million

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 Chart 4 Inflation reduces purchasing value of fixed cash flows

Even low
inflation rates
have a significant
impact on the
purchasing
power
of
fixed cash flows
over
the long term

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 Real yield calculation using CPI inflation
PART 3

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 Economists use nominal
Equation 1 Nominal bond yield decomposition bond yields and
Called the Fisher identity inflation or inflation
expectations to derive
real yields

(1 + y ) = (1 + yreal ) (1 +  )
(1 + y ) = (1 + yreal ) (1 +  e
)
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 Economists use nominal
bond yields and
Nominal yield decomposition inflation or inflation
expectations to derive
real yields
1.Nominal bond yield
2.Inflation component
3.Real yield component
4.Inflation expectation component

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 Table 2 Real 10-year government bond yields in 2017
http://stats.oecd.org/Index.aspx?DataSetCode=MEI_PRICES

Country 10-year CPI Real

1. Economists use bond yield Inflation 10-year
nominal bond yields
and inflation to
bond yield
derive real yields US 2.33% 2.1% 0.23%
2. Real yield =
Japan 0.05% 0.5% -0.45%
10-year bond yield Euro Area 1.17% 1.5% -0.33%
minus CPI inflation
UK 1.24% 2.7% -1.46%

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Equation 2 Real bond yield calculation using actual inflation data

In practice and approximately

real yield = nominal yield – inflation

more precisely

(1 + real yield) = (1 + nominal yield) / (1 + CPI inflation rate)

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Example 2 US real 10-year bond yield calculation
Using 2017 data

US 10-year real yield = unknown

US Nominal 10-year yield = 2.33%

US CPI annual inflation rate = 2.1%

Real yield = 2.33 – 2.1 = 0.23%

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Chart 5 US CPI inflation and 10-year bond yield
CPI-U inflation measure, monthly data, 1950-2013

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Chart 6 US 10-year real yield
10-year nominal yield minus CPI-U inflation, monthly data, 1950-2013

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 Inflation-indexed bonds
PART 4

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Inflation risk

Inflation and the reduction in

the purchasing power of money
is the key risk
for a bond investor
receiving fixed nominal cash payments
over the long term
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Inflation-indexed bonds remove inflation risk

Inflation-indexed bonds
were created to

remove inflation risk

for bond investors

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Inflation-indexed government bonds

The UK government first issued inflation-indexed bonds

(Index-Linked Gilts) in the early 1980s, and the
US government followed suit by introducing
US Treasury inflation-protected securities (TIPS) in 1997.

Inflation-indexed government bonds are available in many other

countries, including Canada, France and Japan.
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Inflation-indexed bonds

1. Inflation-adjusted principal payment

2. Inflation-adjusted coupon interest payments
3. Price quoted in real yield terms
4. A change in inflation, all other things being equal, will have no
effect on the value of inflation-indexed bonds
5. Inflation-indexed bonds are only impacted by changes
in real yields

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US 30-year TIPS inflation-adjusted Principal
Par value $100, inflation 2%, inflation-adjusted principal is paid when the bond matures

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30-year US Treasury TIPS inflation-adjusted Coupon Payments
Coupon interest rate =1% and applied to inflation-adjusted principal

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Two bond markets

A huge
nominal bond market
and a smaller
inflation-indexed bond market
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Inflation-indexed bonds and nominal bonds two bond markets

A nominal bond market with a

nominal yield curve
and an inflation-indexed bond market with a
real yield curve

two yields curves

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 10-year yield = 1.34%
US Treasury nominal yields

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 10-year real yield = -0.80%
US Treasury real yields

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Equation 3 Inflation-indexed bond price using real yields

n
C M
Pil =  +
t =1 (1 + y real ) (1 + yreal )
t n

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 Equation 4 Inflation-indexed bond price using real yields

C  1  M
Pil =  1 − 
n 
+
yreal  (1 + y real )  (1 + y real )n

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Equation 5 Inflation-indexed zero-coupon price using real yields

M
Pzil =
(1 + yreal )n

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 This is the
Equation 6 Zero-coupon bond price formula formula that we are
familiar with

M The yield that we

Pzn =
have been working
with in earlier

(1 + y )
lectures is also
called a

n nominal yield
when we talk about
inflation

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 We all know this already ☺
Interpretation of equation 6

The price of a
zero-coupon bond
will fall if the
yield increases
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Equation 7 Nominal zero-coupon bond price Now it gets
using a real yield and breakeven inflation BEI instead of a nominal yield
more
interesting

M
Pzn =
(1 + yreal )  (1 + bei )
n n

This is the same formula, but now we are using real yield and
breakeven inflation (BEI) instead of the nominal yield
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Interpretation of equation 7

The price of a
nominal zero-coupon bond will fall
if the real yield increases,
and/or the

breakeven inflation rate increases

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 A two-step bond price calculation process
PART 5

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Inflation-indexed bond price is a two step calculation process

1. Index-linked bonds are quoted on a clean price basis

2. The clean price does not include the inflation adjustment

3. The inflation adjustment is the role of the inflation

index ratio
4. The settlement price applies the inflation index ratio to
the clean price
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Two step calculation process

1. Calculate the clean price using a real

yield
2. Apply the inflation index ratio to
calculate the settlement price

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Equation 8 Inflation-indexed bond settlement price formula

 n C M 
SPil = IndexRatio   + n
 t =1 (1 + yreal ) (1 + yreal ) 
t

CPI end
IndexRatio =
CPI start

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Equation 9 Inflation-indexed zero-coupon bond settlement price

 M 
SPil = IndexRatio   n
 (1 + y real ) 
CPI end
IndexRatio =
CPI start
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 Using a -0.5%
Example 3 Inflation-indexed bond price calculation real yield
10-year maturity inflation-indexed bond, 1.5% annual coupon rate, par value=100

10
1.5 100
Pil10 = +
t =1 (1 + ( −0.005) ) (1 + (−0.005) )
t 10

Just like the

Pil10 = 120.5612
bond price
calculation
process we are
familiar with

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Inflation-indexed bond cash flows

1. Inflation-adjusted coupon payments

2. Inflation-adjusted principal payment
3. Uplift for inflation according to the value of the inflation
index ratio

4. The discount factor is determined by a real yield not a

nominal yield
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 Equation 10 Inflation-adjusted principal/maturity value Mil
Inflation-indexed zero-coupon bond, par value = 100
Inflation index ratio

CPI end
100  = M il
CPI start
But we don’t know
this value until the
Inflation-adjusted
maturity value
bond matures

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Example 4 Inflation-adjusted maturity value Mzil
30-year inflation-indexed zero-coupon bond, par value = 100

CPIstart = 100.0000 Inflation index ratio

CPIend = 209.7567

209.7567
M zil 30 = 100  = 209.75676
100.0000
Inflation-adjusted
maturity value
Maturity value

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 Breakeven inflation
PART 6

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Breakeven inflation definition

Breakeven inflation
is defined as the inflation rate needed to equate an

inflation-indexed bond yield

with a nominal bond yield

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Breakeven inflation interpretation

If actual inflation is equal to

breakeven inflation then the
investment return on
the nominal bond and the inflation-indexed bond

will be equal (see example 5, slide 60)

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Breakeven inflation

Breakeven inflation is the

difference between a
nominal bond yield and an
inflation-indexed bond yield
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Breakeven inflation

Inflation-indexed bonds
are analysed on a

breakeven inflation
basis

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Market implied inflation expectations

Breakeven inflation
is viewed as the
market implied expectation
for inflation
for the period corresponding to the
maturity of the bonds that are used

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 Nominal bond market
Chart 7 US 10-year Treasury bond yield
https://fred.stlouisfed.org/series/DGS10

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 Inflation-indexed
Chart 8 US 10-year TIPS real yield bond market
https://fred.stlouisfed.org/series/DFII10

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 Nominal – real yield
Chart 9 US 10-year breakeven inflation rate
https://fred.stlouisfed.org/series/T10YIE

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 5. It’s all
Goldman drops 5 of 6 top trades for 2016 about the
Bloomberg Business, February 9 2016 timing

1. Goldman’s 4. US 10-year
inflation bet breakeven
gone wrong inflation rate
target 2.0%
2. US 10-year
breakeven 3. US 10-year
inflation rate breakeven
starting at inflation rate
sinks to
1.6%
in November
1.2%
2015 in February
2016
Darren Cullen ECOM074 57
 See what happened after
Goldman close their trade at
Chart 10 US 10-year breakeven inflation rate
https://fred.stlouisfed.org/series/T10YIE 1.2%

Rising

Falling

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 Using real yields from the
Equation 1 Nominal yield decomposition inflation-indexed
Called the Fisher identity
bond market

Now we can use

nominal yields
and
real yields
(1 + y ) = (1 + yreal ) (1 +  )
from the

(1 + y ) = (1 + yreal ) (1 +  )
two bond markets
to derive
e
inflation
expectations

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 Remember nominal
yield = real yield +
Example 5 10-year breakeven inflation calculation breakeven inflation

Nominal zero-coupon bond yield = 1.5%

So real yield =
Zero-coupon inflation-indexed real yield = -0.5% nominal yield -
breakeven inflation

Breakeven inflation = 2.0%

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Example 5 Nominal and inflation-indexed zero-coupon prices

100
Pzn = = 86.1667
Open (1 + 0.015)10

positions
at these
prices 100
Pzil = = 105.1403
(1 + (− 0.005))10

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Example 5 Inflation-adjusted principal/maturity value calculation

The inflation-adjusted principal/maturity value at

redemption for the zero-coupon bond in this example is 122.02

M zil10 = 100  (1 + 0.0201) = 122.02

10

We assume actual Inflation = breakeven inflation = ((1+0.015)/(1+(-0.005)))-1 = 0.0201

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 1. The price of the future cash
Example 5 Summary of calculation results flow that is fixed at 100
100
1. 𝑃𝑧10 = 1+0.015 10
= €𝟖𝟔. 𝟏𝟔𝟔𝟕
2. Inflation-indexed
bond clean price
100
2. 𝑃𝑧𝑖𝑙10 = 10 = €𝟏𝟎𝟓. 𝟏𝟒𝟎𝟑
1+ −0.005
10
3. 𝑀𝑧𝑖𝑙10 = 100 × 1 + 0.0201 = €𝟏𝟐𝟐. 𝟎𝟐

3. Inflation-adjusted
principal/maturity
value
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Inflation-indexed bond investment principal/maturity value

Units Inflation- Final value

adjusted
principal/
maturity value

951,110 €122.02 €116 million

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 In this case, the
nominal bond and the
Example 5 Investment return results summary inflation-indexed bond
Investment return if held to maturity IF actual inflation = breakeven inflation at 2% investment return
is the same

Bond Price Initial Units Final Total Annual

Investment value return return
% %

Nominal €86.17 €100 million 1,160,541 €116 million 16.05 1.5

bond (Principal = 100)
Inflation- €105.14 €100 million 951,110 €116 million 16.05 1.5
indexed (Principal =
bond 122.02)

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 Breakeven inflation bond trading strategies
PART 7

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Strategy 1 Breakeven inflation is expected to rise

Expect
breakeven inflation
to increase

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Strategy 1 Breakeven inflation is expected to rise

Nominal yield
increase must be larger than the
corresponding increase in the

inflation-indexed yield
for this to happen
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 Outperform
means the
Strategy 1 Breakeven inflation is expected to rise investment return
is higher

Inflation-indexed bonds
outperform
nominal bonds

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Strategy 1 Breakeven inflation is expected to rise

Buy inflation-indexed bond

Sell nominal bond

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 Buy inflation-
indexed
Example 6 Expect US 10-year breakeven inflation to increase Sell nominal

10-year Treasury 10-year Treasury 10-year breakeven

nominal bond inflation-indexed inflation rate
bond
Open position 2.30% 0.70% 1.6%
yields
Opening prices $79.661 $93.262
Position size $100 mn $100 mn
Units -1.2553 mn 1.0722 mn

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 Example 6 Nominal and index-linked zero-coupon bond prices

Sell
100 nominal
𝑃𝑧𝑛10 = 10
= 79.661 bond
Open 1 + 0.023
positions
at these
Buy
prices 100 inflation-
𝑃𝑧𝑖𝑙10 = 10
= 93.262
1 + 0.007 indexed
bond

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 Buy inflation-
indexed
However, there is bad news and the strategy is closed Sell nominal

The market has moved against our

position and 10-year breakeven
inflation has fallen to 1.2%
so we have to close our position
Darren Cullen ECOM074 73
 Buy inflation-
indexed
Example 6 Close positions at BEI 1.2% loss $4.1 million Sell nominal

10-year Treasury 10-year Treasury 10-year breakeven

nominal bond yield inflation-indexed real inflation rate
yield
Close position 1.7% 0.5% 1.2%
yields
Closing prices $84.487 $95.135

Value -$106.1 mn $102.0 mn -$4.1 mn

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 Buy inflation-
indexed
But another investor chooses to keep the strategy Sell nominal

In this case the position is kept

and is closed after
10-year breakeven inflation
has increased to 2.05%
Darren Cullen ECOM074 75
 Buy inflation-
indexed
Example 6 Close positions at BEI 2.05% profit $4.25 million Sell nominal

10-year Treasury 10-year Treasury 10-year breakeven

nominal bond yield inflation-indexed real inflation rate
yield

Close 2.83% 0.78% 2.05%

positions
Price $75.649 $92.524

Value -$94.96 mn $99.21 mn $4.25 mn

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 Buy inflation-
indexed
If we say this was a one-year strategy Sell nominal

1. The inflation-indexed bond prices we have calculated so

far have been what are known as clean prices
2. For longer time period position we need to apply the
inflation index ratio for the inflation-linked
bond price
3. This means that this strategy will make more profit
Darren Cullen ECOM074 77
Inflation-indexed bond settlement price calculation
10-year
Inflation index ratio inflation-
indexed bond
clean price

1.02
𝑆𝑃𝑧𝑖𝑙10 = × 𝑃𝑧𝑖𝑙10 = 1.02 × 92.524 = 94.375
1.00

Assuming actual CPI inflation is 2% for the year that the position is held

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 Buy inflation-
indexed
Example 6 Close positions at BEI 2.05% profit $6.23 million Sell nominal
Assuming position held for one year, actual inflation = 2% and using settlement price

10-year Treasury 10-year Treasury 10-year breakeven

nominal bond yield inflation-indexed real inflation rate
yield

Close 2.83% 0.78% 2.05%

positions
Closing $75.649 $94.375
prices
Value -$94.96 mn $101.19 mn $6.23 mn
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Strategy 2 Breakeven inflation is expected to fall

Expect
breakeven inflation
to fall

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Strategy 2 Breakeven inflation is expected to fall

Nominal yield decline

must be larger than the
inflation-indexed yield decline
for this to happen
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Strategy 2 Breakeven inflation is expected to fall

Nominal bonds
outperform
inflation-indexed bonds

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Strategy 2 Breakeven inflation is expected to fall

Buy nominal bond

Sell index-linked bond

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 d.cullen@qmul.ac.uk
QUESTIONS

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 Appendix

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What is inflation and why does it matter?
Guardian, February 5 2018

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What is inflation and why does it matter?
Guardian, February 5 2018

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