Week 8 Flashcards
The payoffs each period on ILBs reflect
a real yield plus an additional payment to compensate for realized inflation either via the coupon, or adjusting the face value
If ILBs are held to maturity
the total return reflects the real yield on purchase plus an adjustment for inflation over the whole period
However, returns during any particular period (e.g. a month) reflect these payoffs, plus any capital gain/loss stemming from changes in the (real) yield on the security.
what will impact the short-term ILB return
returns during any particular period (e.g. a month) reflect these payoffs, plus any capital gain/loss stemming from changes in the (real) yield on the security
short-term ILB return
we refer to “short-term” return we assume the ILB is not held to maturity.
Instead, it is sold prior to maturity so the selling price, and therefore the return, will be impacted by changes in the real yield during the time in which the ILB is held
Break-even inflation
It is a measure of the rate of inflation that would result in conventional bonds and ILBs generating the same return if held to maturity.
What are the drivers of ILB returns?
Potential fundamental drivers of changes in ILB yields
- Increasing familiarity
– ILBs might have been mis-priced (yields were too high) when they first emerged during the 1980s, then declined as market became more familiar with the asset. (Note: This would be an example of an ‘exotic beta’.)
What are the drivers of ILB returns?
Potential fundamental drivers of changes in ILB yields
- Supply/demand factors, specifically hedging demand
Demand for ILBs for inflation hedging and LDI purposes seems to have increased over time, particularly in the UK and US towards the end of the period. This is another possible contributor to the decline in ILB yields over time.
What are the drivers of ILB returns?
Potential fundamental drivers of changes in ILB yields
- Changes in liquidity
– Like many assets, the required return and hence yields on ILBs may be influenced by liquidity considerations. One possible contributor to the decline of yields through time is that the asset class became more liquid as ILBs became more widely available and traded.
What are the drivers of ILB returns?
Potential fundamental drivers of changes in ILB yields
- Fluctuations in real interest rates
ILB yields reflect real interest rates (which generally declined over the time period of the data provided, resulting in capital gains).
Note that conventional 10-year bonds yields less CPI (another real interest rate proxy) has also trended down
What are the drivers of ILB returns?
Potential fundamental drivers of changes in ILB yields:
- Fluctuations in real interest rates
- Changes in liquidity
- Supply/demand factors, specifically hedging demand
- Increasing familiarity
What are the drivers of ILB returns?
returns are a function of
rates
Reinvestment rates: more minor relevance
What are the drivers of ILB returns?
returns are a function of
Payoffs’ during each period, comprising of ILB yield (real) plus inflation adjustment via the face value or coupon. Bulk of returns comprises these two components if held to maturity
What are the drivers of ILB returns?
returns are a function of
short term
Capital gains or losses due to fluctuations in ILB yields: a key driver in short term. ILBs tend to have low yields and long duration, and hence price can be relatively sensitive to yield changes
Influences on the ‘break-even inflation rate’ (difference between conventional and ILB yields)
- Supply/demand pressures
The weight of buyers versus sellers can influence relative yields in the shorter term. Again, hedging demand for ILBs may have played a role in recent periods.
Influences on the ‘break-even inflation rate’ (difference between conventional and ILB yields)
- Relative liquidity
to the extent that ILBs are less liquid, their yields might be buoyed relative to conventional government bonds (which are very liquid). This may impact the break-even inflation rate in a downward direction.
Influences on the ‘break-even inflation rate’ (difference between conventional and ILB yields)
- Inflation risk premium
As conventional bonds are exposed to inflation risk, they may contain an inflation risk premium which buoys their yields relative to ILBs. This may impact the break-even inflation rate in an upward direction.
Influences on the ‘break-even inflation rate’ (difference between conventional and ILB yields)
- Inflation expectations
These are the key driver. The charts show that the conventional versus ILB yield differential appears to broadly trend along with realized inflation (bearing in mind that realized inflation is a rough proxy for expected inflation)
Influences on the ‘break-even inflation rate’ (difference between conventional and ILB yields):
- Inflation expectations -
- Inflation risk premium
- Relative liquidity -
- Supply/demand pressures -
The effectiveness of ILBs as an inflation hedge depends on investment horizon
Shorter term -
Effectiveness of the hedge is also subject to what happens to ILB yields and hence ILBs returns during inflationary periods. To investigate, you might examine the following:
- The relation with both historical inflation and expected inflation.
. The reason to distinguish is that, to the extent that some level of inflation is already anticipated built into the market, then it is changes in inflation expectations that provide the ‘innovation’ and hence may matter most.
Inflation expectations are hard to observe, although the break-even inflation rate (= conventional less ILB yields) can provide a reasonable proxy.
The effectiveness of ILBs as an inflation hedge depends on investment horizon
Shorter term -
Effectiveness of the hedge is also subject to what happens to ILB yields and hence ILBs returns during inflationary periods. To investigate, you might examine the following:
- Whether ILB yields are negatively correlated with inflation
- Whether ILB returns are positively correlated with inflation
- The relation with both historical inflation and expected inflation.
The effectiveness of ILBs as an inflation hedge depends on investment horizon
Longer-term
- ILBs provide an inflation hedge if held to maturity, given that cash payments are adjusted for inflation, usually measured by CPI.
However, the integrity of this hedge is subject to the appropriateness of CPI (or the index used) as a measure of inflation.
The effectiveness of ILBs as an inflation hedge depends on
investment horizon to a large extent
Are ILBs closest thing to the risk-free asset?
• Certain aspects of the data suggest that ILBs might actually be riskier than conventional bonds b/c
For the global series, the correlation between equity and ILB returns
os slightly positive at 0.03, whereas the correlation between equity and conventional FI returns is negative at -0.21.
This suggests conventional bonds provide better diversification benefits for equity-dominated portfolios. For Australia the correlations are positive but modest (0.09, 0.17)
Are ILBs closest thing to the risk-free asset?
• Certain aspects of the data suggest that ILBs might actually be riskier than
convention bonds on some dimensions:
Standard deviation of ILB returns is higher than the standard deviation of conventional FI returns (5.35% versus 3.76%
The global ILB market duration is mainly driven by the UK inflation-link gilts that mature in 50 years. Although the demand for ILB has been increasing especially in the UK and US, the ILB market is tiny compared with traditional bond market and therefore is much less liquid.
