Global Inflation Context
Inflation linked bonds play a key role in providing inflation protection for investors. As we head into a meeting of the Federal Reserve this week, the market is still looking for clues on the central bank’s policy-easing path over the next few months. Even though the Fed is widely expected to keep interest rates unchanged, inflation risks remain as the US labour market remains tight.
Inflation across the globe has slowed down from the highs of 2023 Q3 which was fuelled by the supply side constraints emanating from the COVID 19 pandemic and various stimulus packages to support households during the pandemic. While most of the COVID 19 pandemic supply side constraints have dissipated, geopolitical risks have increased, and inflation is coming down at a slower rate than initially expected.
Locally, inflation is now within the South Africa Reserve Bank’s (SARB) 3% – 6% target band, but it is only expected to fall to the 4.5% mid-point preferred by the SARB in the first quarter of 2025. This points to reduced inflation risks over the medium term which typically results in less demand for inflation linked protection and is reflected in higher real yields on inflation linked bonds.
As our market has gone through periods of higher and lower inflation risk over time, how have inflation linked bonds performed relative to nominal bonds? Have investment in inflation linked bonds really provided effective inflation protection? Finally, is there still a case for investors to invest in inflation linked bonds given the current macroeconomic environment where inflation risks are falling?
History of Inflation Linked Instruments.
An inflation-linked bond is a type of debt security designed to protect investors from inflation by adjusting their principal amounts based on broad price changes to maintain their real value. Capital and interest payments (the coupon) are linked to the South African Consumer Price Index (CPI) – Headline CPI is used. The interest payments on these bonds are typically a fixed percentage of the adjusted principal. Therefore, as inflation increases, both the principal and the interest payments increase. The primary objective of inflation-linked bonds is to preserve the purchasing power of the investor’s capital by providing returns that keep pace with inflation.
The first Inflation-linked instrument in the South African market was an inflation-linked annuity by the N1 toll road in 1995. There were further toll-road issuances with different profiles until 2021. The first Government inflation linked bond (R189) was issued in 2000. The issuances widened over time to include government guaranteed paper issued by State Owned Companies (SOCs) like Sanral, Transnet, and Eskom. The history of inflation-linked instruments highlights the role that they have played in providing exposure to infrastructure assets, firstly through the road and water infrastructure and thereafter indirectly through funding the SOCs. Inflation linked instruments have always played a critical role in the hedging of long-term liabilities by Pension funds and insurance companies, which explains the increased issuance of inflation linked paper by banks around 2009. Issuance of inflation linked paper by Corporates has never taken off and there has been a notable decline in the issuance of new inflation-linked bonds since 2017, primarily due to reduced issuance from SOCs. Inflation linked bonds made up only 13.3% of the total amount outstanding for debt instruments listed on the Johannesburg Stock Exchange (JSE) in March 2023.
Source: RMB. JSE
The largest holders of inflation linked bonds are Pension Funds and Insurance companies. These investors typically buy and hold the bonds to hedge their liabilities. Investors with a shorter-term investment horizon that look to gain exposure to inflation accruals hold shorter duration bonds. Foreign participants are generally not active in the inflation linked bond market relative to the nominal bond market where they hold 29.47% % of the total bond holdings.
Source: National Treasury
How have inflation linked bonds performed relative to nominal bonds?
The chart below shows the relative performance of nominal bonds (ABLI index) and inflation linked bonds (CILI index) over time against YoY CPI. The short-term direction of CPI is key to the relative performance. Inflation linked bonds outperform nominal bonds in periods where CPI is increasing and there is elevated inflation risk. There is therefore a strong positive relationship between CILI Index outperformance relative to the ALBI Index when CPI starts bottoming or accelerates higher such as the period from June 2020 to June 2022. After that date, CPI began to slow owing to base effects, the impact of global and local rate hikes, and cooling commodity prices. Nominal bonds have become more attractive on a relative basis as inflation momentum diminished from June 2022.
Source: Bloomberg
An analysis of the relative returns over time shows that nominal bonds have outperformed inflation linked bonds over the long term. Nominal bonds perform better in an environment of stable economic conditions and an expansionary growth cycle where inflation is stable to falling, with prudent government fiscal and monetary policies. The difference in returns between the ALBI index and the CILI index will also reflect the impact of yields changes on the total returns in addition to the impact of inflation.
Source: Prowess March 2024
Investors ideally require a dynamic strategy that can rotate between inflation linked bonds and nominal bonds based on the prevailing market conditions. That requires analysis of inflation breakeven rates against where inflation is expected to be in the future. The breakeven inflation rate is the difference between the nominal bond yield and the real yield on an inflation-linked bond of the same maturity. The breakeven inflation rate is not a direct measure of inflation expectations as it contains an inflation risk premium that reflects that future inflation is uncertain and a premium that reflects low liquidity in inflation-linked bonds. However, the breakeven inflation rate can be used by investors to infer market expectations of long-term inflation. If an investor expects future inflation at a higher rate than where the markets are currently pricing the breakeven inflation rate, then that investor would prefer inflation linked bonds over nominal bonds in search of a higher relative real return.
The question then becomes whether investing in inflation linked bonds have provided protection against inflation. The chart below shows how investing in the CILI index provided inflation protection over time?
Source: Prowess March 2024
The recent performance reflects the negative impact of higher real yields on inflation linked bond returns as central banks increased interest rates. Investors are typically worried about inflation risks in the long term, so the CILI index has performed well relative to CPI over the longer time periods up to 5 years.
Is there still a case for keeping exposure to inflation linked bonds?
The inflation outlook remains uncertain even though the rate hike cycle has peaked. It will still take some time for inflation to fall to the target levels of the central banks. There is also the risk that there has been a change in the inflation regime leading to higher natural inflation levels than in past decades due to geopolitical risks that continue to pressure commodity prices, and the potential for climate change to impact parts of the economy through more frequent weather-related disasters. The shift to the ‘Green Transition’ may result in an increase in energy prices and the phasing out of CO2-intensive technologies may prove to be inflationary.
The biggest holders of inflation linked bonds are retirement funds who use the bonds to hedge their long-dated liabilities. The current elevated level of real yields provides an opportunity to hedge the liabilities at attractive levels. For other investors, the inflation accrual is just one of the components of the total return from inflation linked bonds. Inflation-linked bonds stand to benefit from the capital gains from a fall in real yields as inflation falls and central banks start to cut rates. Inflation-linked bonds also offer diversification benefits within portfolios in addition to providing the inflation protection.