The payment of interest income on the principal of an index-linked bond is connected to a certain price index, usually the Consumer Price Index (CPI). This feature provides safety to investors by protecting them from changes in the underlying index. The cash flows of the bond are modified so that the bond holder receives a known real rate of return. In Canada, an index-linked bond is known as a real return bond, in the United States as Treasury Inflation-Protected Securities (TIPS), and in the United Kingdom as a linker.
What are index-linked bonds?
An index-linked bond is one whose coupon payments are linked to an inflation indicator, such as the Consumer Price Index (CPI) or the Retail Price Index (RPI), to account for inflation (RPI). These interest-bearing investments often offer investors a real yield plus inflation, so providing an inflation hedge. Real figures, not nominal ones, are used to determine the yield, payment, and principal amount. The CPI can be thought of as the rate at which the return on a bond investment is converted to a real return.
Is it wise to invest in index-linked bonds?
Fixed-income assets can be harmed by inflation, which reduces their purchasing power and reduces their real returns over time. Even if the pace of inflation is moderate, this can happen. If you have a portfolio that returns 9% and the inflation rate is 3%, your real returns will be around 6%. Because they increase in value during inflationary periods, inflation-index-linked bonds can help to mitigate inflation risk.
Is it wise to invest in inflation-linked bonds?
Conclusion. Because the holding returns are directly impacted by changes in the Consumer Price Index, owning inflation-indexed bonds, such as U.S. Treasury Inflation Protected Securities or Series I Savings Bonds, is the safest and most easy way to acquire inflation protection.
What countries are the issuers of index-linked bonds?
Treasury Inflation-Protected Securities (TIPS), a form of US Treasury securities, are the most liquid instruments, with about $500 billion in issuance. The UK Index-linked Gilts market, with over $300 billion in outstanding, and the French OATi/OATi market, with over $200 billion in outstanding, are two other large inflation-linked markets. Inflation-indexed bonds are also issued by Germany, Canada, Greece, Australia, Italy, Japan, Sweden, Israel, and Iceland, as well as a number of Emerging Markets, most notably Brazil.
Is it wise to buy in tips in 2021?
TIPS (Treasury Inflation Protected Securities) have a 7.7-year maturity date as of October 29, 2021. The sensitivity of a bond or bond fund to interest rate changes is measured by its duration. The longer the tenure of a bond, the more sensitive it is to interest rate changes. That indicates that if US Treasury rates climb by 1%, the price of TIPS might fall by 7.7%. “Wait,” you might be thinking to yourself. Aren’t TIPS supposed to shield investors from rising interest rates?” “Not nearly,” is the quick answer.
TIPS can help shield investors from growing inflation expectations rather than actual inflation or rising interest rates. While our analysis shows that TIPS have historically outperformed Treasurys during rising interest rate times, hedging interest rate risk (rather than inflation predictions) has shown to be a more directand effectivesolution.
During rising interest rates, interest rate-hedged corporate bonds outperformed TIPS – Index Comparison
Bloomberg, from December 31, 2013, through September 30, 2021. Based on quarterly fluctuations in the 10-Year Treasury yield, this is the average performance. Any calendar quarter in which the 10-Year Treasury yield climbed is considered a rising rate period. The FTSE Corporate Investment-Grade (Treasury-Rate Hedged) Index represents Interest Rate Hedged Bonds. The Bloomberg U.S. Treasury Index represents “Treasuries.” The Bloomberg U.S. TIPS Index represents TIPS.
When interest rates rise, inflation expectations rise as well, which is why, as the chart above indicates, TIPS have historically outperformed conventional Treasurys when rates have climbed. Because interest rates might rise even if inflation forecasts remain unchanged, the FTSE Corporate Investment Grade (Treasury Rate-Hedged) Index has performed even better. In reality, the Fed’s tapering policy is designed to accomplish just that. The goal is to achieve a rise in interest rates that is either: a) independent of rising inflation expectations; or b) independent of rising inflation expectations. And that’s a recipe for a poor TIPS performance.
TIPS also necessitates a quick refresher on the distinction between inflation expectations and actual inflation. TIPS often perform well when future inflation expectations grow, not when present inflation measures rise. According to the Bloomberg U.S. TIPS Index, TIPS have done well so far in 2021, up about 5% through October 29th. As a result, rising inflation expectations may have already been reflected in TIPS pricing.
The difference between the yields on TIPS and a nominal (or usual) Treasury at the same maturity is used to determine breakeven inflation rates. Investors can use breakeven rates to estimate what the rate of inflation will be over a given time period. Let’s take a look at those expectations in more detail.
At the end of October, the 10-year breakeven rate was 2.6 percent, greater than the Fed’s 2 percent inflation target. Breakeven inflation expectations could fall if investors believe current inflation levels are only temporary, putting pressure on TIPS performance versus the broader fixed asset market.
Investing in TIPS now, when real interest rates are exceptionally low and inflation expectations are high, could be a mistake. The Fed is likely to want real interest rates to climb in the future while keeping inflation under control. With interest rate risk and credit risk serving as the key drivers of return for bond strategies, now might be the moment to favor credit risk. Consider interest rate hedged bond strategies, which invest in investment grade or high yield bond portfolios with built-in interest rate hedges that specifically target the impact of rising Treasury rates.
ProShares Investment GradeInterest Rate Hedged is one technique for investors interested in investment grade fixed income investments (IGHG).
- A diversified portfolio of investment-grade corporate bonds provides return potential.
- Has an interest rate hedge that targets zero interest rate risk using short Treasury futures.
This data is not intended to be used as investment advice. The effectiveness of the strategies presented cannot be guaranteed. Investment comparisons are provided for informational reasons only and are not intended to be exhaustive.
Any forward-looking statements made here are based on ProShare Advisors LLC’s current expectations. ProShare Advisors LLC disclaims any obligation to update or alter any forward-looking statements as a result of new information, future events, or other factors.
Additional risks and uncertainties associated with COVID-19 are currently present, including general economic, market, and business conditions; changes in laws or regulations, or other measures taken by governmental authorities or regulatory organizations; and global economic and political developments.
Investing entails risk, including the possibility of losing money. Risks related with the use of derivatives (swap agreements, futures contracts, and similar instruments), imperfect benchmark correlation, leverage, and market price variance, all of which can increase volatility and lower performance, are all present in this ProShares ETF. For a more detailed understanding of risks, please view the summary and full prospectus. Any ProShares ETF has no guarantee of meeting its investing objective.
The fund focuses its investments on a few industries. Narrowly concentrated investments are known to be more volatile.
Other than rising Treasury interest rates, IGHG makes no attempt to offset factors that affect the price and yield of corporate bonds, such as changes in the market’s perception of the corporate entity’s underlying credit risk. By holding short positions in Treasury futures, IGHG hopes to protect investment grade bonds from the detrimental effects of increasing rates. As Treasury prices rise, these bets lose value. The short positions are not meant to minimize credit risk or other factors that may have a greater influence on bond prices than increasing or falling interest rates. When interest rates remain steady or fall, investors may be better off investing in a long-only investment grade investment rather than IGHG, as hedging may limit possible gains or increase losses. There is no such thing as an ideal hedge. Because the length hedge is adjusted on a monthly basis, interest rate risk can develop during the month, and the short positions do not guarantee that interest rate risk is totally eliminated. Furthermore, while IGHG aims for a zero effective duration, it is unable to completely account for changes in the form of the Treasury interest rate (yield) curve. Long-only investment grade bond investments may be more volatile than IGHG. If investment grade credit deteriorates at the same time that Treasury interest rates fall, IGHG’s performance could be particularly negative. There is no guarantee that the fund will make a profit.
Before investing, carefully evaluate the investment objectives, risks, charges, and fees of ProShares. Their short and complete prospectuses contain this and other information. Before you invest, make sure you read them thoroughly.
ProShares has been granted permission to use the terms “FTSE” and “FTSE Corporate Investment Grade (Treasury Rate Hedged).” The London Stock Exchange Plc and The Financial Times Limited own the FTSE trademark, which is used by FTSE International Limited (“FTSE”) under license. FTSE or its affiliates have not verified the legality or suitability of ProShares. FTSE or its affiliates do not sponsor, recommend, sell, or promote ProShares based on the FTSE Corporate Investment Grade (Treasury Rate Hedged) Index, and they make no representation about the advisability of investing in ProShares. WITH RESPECT TO PROSHARES, THIS ENTITY AND ITS AFFILIATES MAKE NO WARRANTIES AND ASSUME NO LIABILITY.
SEI Investments Distribution Co., which is not linked with the funds’ advisor, distributes ProShares.
Are index-linked bonds considered fixed-income securities?
Index-linked bonds are fixed-income instruments that are linked to an inflation index to safeguard cash flows’ real value during inflation. Linkers are issued in the United Kingdom, Treasury Inflation-Protected Securities (TIPS) are issued in the United States, and Real Return Bonds are issued in Canada (RRBs).
How do index-linked gilts get their price?
What factors go into determining the yields and redemption amounts? You may get a thorough explanation on the government’s Debt Management Office (DMO) website, but be warned: it’s really complicated.
The important explanation is as follows: ‘Index-linked gilts pay semi-annual cashflows that are tied to the Consumer Price Index.’
In practice, this means that both the coupons and the principal have been changed to reflect inflation when the gilt was first issued.
On this basis, you might conclude that the only relationship you need to comprehend is the one between the linker’s price, yield, and the rate of inflation. As a result, if inflation rises, will the yield and redemption amount rise as well? But there’s another relationship to consider: the market relationships between traditional (non-index linked) gilts and linkers.
Simply put, bond investors will be enticed to buy index-linkers only if they believe they are being adequately compensated in comparison to alternative yield products. In other words, why would you buy a linker with a negative real yield when you could buy traditional gilts with a positive real yield?
Some investors may choose to disregard the difference in order to keep the ‘inflation insurance’ component, but I believe the vast majority of investors would simply sell the negative real-yielding linker bonds and buy positive real-yielding traditional gilts instead.
What this means and the worst case scenario
This, according to Williams of Charteris, is a possibility. He points out that during the last 40 years of linkers’ existence, index-linked gilts have traded at positive real yields of 3% or more for a considerable amount of that time (between a quarter and a third), peaking at nearly 5% shortly before the 1987 sell-off.
These years of pricing data also provide some benchmarks against which we may assess the anticipated relationship between traditional gilts and linkers.
And there’s one more crucial factor to consider. Because the price volatility of linkers is substantially higher than that of traditional gilts, if real rates move aggressively, you should expect linkers to move much more aggressively.
Williams offers the UK index-linked 0.125 percent 2068 gilt as an example of a long-dated linker, which is presently trading at roughly £283, implying a negative real yield of about 2%.
If inflation starts to rise, we can expect real yields on traditional gilts to begin to move from negative to positive territory. To estimate the anticipated impact on index-linkers, Williams enters the essential figures into Bloomberg’s calculating engine.
So, if real gilt yields flatten out at 0%, the index-linked gilt drops in price to £105, resulting in a 63 percent loss – remember, prices move in the opposite direction of yields. At + 4%, a figure last seen in the 1980s, the price plummets to £18, a 94 percent loss.
So how likely is this?
If real yields were at 4%, I believe we’d be in the midst of a stagflationary situation. Even if they ignore the rates on offer elsewhere, some investors may choose to hold linkers as a form of insurance. This means that those prices may not collapse as precipitously as the models predict, but make no mistake: if real yields on traditional bonds rise, linkers’ value may plummet.
You could argue that this is all alarmist nonsense, and that the chances of real yields flying over 1% and then 3% are quite remote. Perhaps, but the sheer volume of government debt being issued is awe-inspiring. If the Bank of England begins to aggressively taper its bond-buying program, the gilt market may become a buyer’s market.
Investors may argue that they should be compensated for taking on more risk and that they seek positive real returns. It might happen, and if that thinking takes hold, there’s a chance investors could overreact and pursue positive real yields even higher. I admit it’s unlikely, but not impossible.
The essential point made by Williams is that if conventional gilt yields went closer to’say 6 percent’ (the long-term 300-year average) and CPI rose to’say 3 percent,’ the conventional gilt (much like the US 30-year Treasury right now) would be on a positive real yield,’ he stated.
‘As a result, index-linked gilts would trade on a positive real yield, as they do in the United States, because no one will buy a linker with a negative real yield while the conventional gilt has a positive real yield.’ That is why inflation is negative for index-linked gilts as a whole.’
The usual caveats apply now. Perhaps this partnership will fall apart in the future. As I previously stated, I am not sure that real rates will emerge or climb significantly. If the government’s DMO believes losses are escalating, it may re-enter the market aggressively.
But my point is to debunk the popular belief that index-linked gilts are a simple inflation hedge. No, they aren’t.
I’ll leave you with one final somber notion. Because most private investors don’t possess a lot of index-linked gilts, this may all seem a little academic. However, because linkers make up a large part of many pension fund portfolios, a significant drop in index-linked gilts might exacerbate current pension deficits.
Are inflation-indexed bonds profitable?
Although inflation is normally terrible for the profitability of any fixed-income instrument since it raises interest rates, an inflation-indexed security ensures a genuine return. The most common type of real return securities is a bond or note, but they can also take different forms. Because these securities provide investors with a high level of safety, the coupons linked to them are often lower than those attached to notes with a higher amount of risk. For investors, there is always a risk-reward ratio to consider. On inflation-indexed securities, the periodic coupon is equal to the product of the daily inflation index and the nominal coupon rate. A spike in coupon payments is caused by an increase in inflation expectations, real rates, or both.
Is it ever a good idea to invest in a bond with a negative interest rate?
If traders believe the yield will fall further into negative territory, they will be eager to acquire a negative-yielding bond. Fixed-income prices and yields move in opposite directions, so if a bond yield falls even further, the bond price will rise, allowing the trader to profit.
EE bonds or I bonds: which is better?
If an I bond is used to pay for eligible higher educational expenses in the same way that EE bonds are, the accompanying interest can be deducted from income, according to the Treasury Department. Interest rates and inflation rates have favored series I bonds over EE bonds since their introduction.