When investing in inflation-linked bonds across the globe, it may be tempting to simply favor markets with high real yields, or to pick up yield either through maturity extension or by leaving currencies unhedged. But we think valuation decisions require a more nuanced approach, mixing a little bit of art and science. Investors should delve deeper into the forces behind real (inflation-adjusted) rates – consider central bank policies, credit risk and structural factors before making active management decisions.
PIMCO currently invests in inflation-linked bonds (ILBs) issued by countries spanning the globe with real yields (10-year maturity) ranging from –0.5% to 6% (see Figure 1). We like three countries in particular: Brazil, Australia and the U.S. Brazil’s ILBs offer high real rates in a slowing economy and are secularly attractive on a currency-unhedged basis. Australia, currently rated AAA by S&P, has a strong balance sheet and is likely to run looser monetary policy than in the past as its economy adjusts to the slowdown of the decade-long mining boom. The U.S., on the other hand, is attractive as the central bank attempts to safely delever the post-crisis economy by running negative real policy rates for longer than the market expects, and because we expect a gradual rise in inflation over a secular period. Dr. Janet Yellen’s Fed chair nomination and expected confirmation make the case for investing in U.S. Treasury Inflation-Protected Securities (TIPS) even stronger, as she is generally expected to continue Ben Bernanke’s focus on improving employment.
Real yield to GDP varies by country
When looking at ILBs, the first thing investors are likely to consider is the real yield – they might expect it to be correlated with real GDP growth. Figure 2 shows current 10-year real rates minus expected 10-year GDP growth in the respective countries. As you can see, real rate valuations often diverge from their GDP anchor. There are a host of different reasons for this divergence, some cyclical, others structural in nature. We will explore some of these reasons in greater detail.
Central bank policies are a major reason why numerous developed market countries have real yields significantly below GDP. The big four central banks – the Fed, the European Central Bank (ECB), the Bank of Japan (BoJ) and the Bank of England (BoE) – are all running highly accommodative monetary policies by keeping the policy rate essentially near 0% along with forward-guiding the policy rate, and the Fed and BoJ are also directly intervening in asset markets via purchases of long-term government bonds. Both of these policies are intended to suppress nominal rates and raise inflation expectations, thereby lowering the expected path of real policy rates. As seen in Figure 2, real rate differentials to GDP growth in the U.S., Germany, Japan and the U.K. are in the –1.5% area. Germany additionally benefits from the flight to safety engendered by the eurozone peripheral crisis. Japan is likely to be the most repressive interest rate regime going forward given the current Abe/Kuroda fiscal/monetary policy mix. In fact, Japan issued a 10-year ILB recently at a –0.35% real yield after an issuance hiatus of five years.
Credit risk also plays a big role as investors demand higher real yields to compensate for perceived default risks. Italian yields are still 2.5% over Germany’s despite its slightly lower GDP trajectory as the eurozone crisis continues to affect investor attitudes toward peripheral debt. Brazilian real yields are also very high – at 6% now – because of a large credit risk premium (among other reasons). Both Brazil and Italy five-year credit default swaps are currently at 200 basis points.
Regulatory frameworks such as liability-driven investment (LDI) rules need to be examined. The U.K., for example, has structurally lower long-term real yields as pension schemes have large inflation-linked liabilities and are required to index benefits payments to the rate of inflation.
Credit intermediation: A good case in point here is Brazil, which features subsidized lending to the public sector via the Brazilian Development Bank. This intermediation of credit markets lowers the efficacy and transmission mechanism of central bank policy. All else equal, it leads to higher equilibrium real rates in Brazil (see IMF Working Paper, “The Puzzle of Brazil’s High Interest Rates,” Alex Segura-Ubiergo, February 2012).
Liquidity premium: Investors should always consider the liquidity of their investments and demand a yield premium to own less-liquid assets. Inflation-linked bonds are generally less liquid than their nominal counterparts. U.S. TIPS are the most liquid ILBs; New Zealand and Colombia are good examples of countries that warrant a liquidity premium.
Central bank credibility/inflation risk premium: Any analysis of global ILBs must obviously take into account the level of inflation priced into the bonds – or “breakeven inflation,” in ILB jargon. Breakeven inflation is the level of realized inflation that would result in equal returns from both ILBs and nominal bonds of a country over the life of the bond. Breakeven inflation rates largely depend on central bank inflation targets. Also, the breakeven rates fluctuate based on perceived output gaps – the difference between actual and potential GDP – since the gaps are indicators of inflation potential.
However, the ILBs issued by many emerging market countries with a history of high and volatile inflation will usually trade with a high structural inflation risk premium. That is, the breakeven inflation rate will be a fair bit higher than the central bank’s inflation target (or midpoint of range) because the market may be questioning the central bank’s credibility. Turkey is a good example, where the 10-year breakeven inflation rate is at 6.2% while the central bank inflation target is 5%.
So, ILB investors must also make a judgment call on central bank credibility – not only in emerging market countries but also in many developed countries that have, post-crisis, resorted to unconventional monetary policies that pose an omnipresent threat to their inflation-fighting credentials. Finally, many of the emerging market countries with real rates below GDP are the countries that have run relatively easy monetary policies. For example, realized real short rates in Thailand, Chile and South Korea have been around 3%–5% below realized GDP over the last 10 years. However, such low rates relative to GDP do not necessarily translate to overvalued ILBs – investors should assess the macroeconomic picture in each country.
Other factors to consider
We also consider carry, term premium, volatility and the potential return to be gained or lost by hedging out the currency or leaving it unhedged. Finally, we also try to forecast possible government and central bank actions that could make the investment more or less attractive than it appears.
The bottom line is that any relative value judgment in the global ILB market on country and curve selection requires analysis of a host of economic and market factors. Accordingly, PIMCO takes a multifaceted approach to investing in these markets.