Inflation-Linked Bond ETFs – Time To Buy?

The recent deflation scare has driven yields on conventional government bonds to all-time lows in many countries. According to the Financial Times, as at the close of business on Friday 12 December, benchmark 10-year government bond yields in some major markets were 2.59% (US), 3.60% (UK), 3.73% (France), 3.30% (Germany), 1.40% (Japan), and 3.04% (Canada).

Less noticed has been the rise in index- or inflation-linked bond real yields so far this year. Federal Reserve data show the 10-year TIPS (Treasury Inflation-Protected Security) real yield (i.e., the yield over and above the indexed inflation rate during the life of the bond) rising from a low of 0.90% in March this year to a peak of 3.15% on 21 November, before falling back to the current level of around 2.6%.

This rise in real yields has been reflected in a sharp fall in the price of benchmark inflation-linked bond indices. For example, the Barclays World Government Inflation-linked Bond Index fell from a peak of 236 in late August to a low of 211 in November, before recovering slightly to the current level of around 217.

Of course this is understandable if one expects a period of falling prices—cash and conventional fixed-rate bonds would be far preferable to inflation-linked securities, since the latter would suffer from what had previously been regarded as their key attraction—the indexation of the capital value at redemption (and the interim coupon payments) to the inflation rate.

I recently quoted Dan Draper of Lyxor in my blog as pointing out that inflation-linked ETFs might offer an interesting contrarian play for 2009, particularly since they have seen some of the heaviest client outflows at Lyxor over recent months, and so it seems worthwhile to dig a little deeper into current market valuations, and to review European ETF investors’ options within this sector.

One useful way to compare the relative attractiveness of conventional (fixed-rate) and inflation-linked bonds is to calculate break-even inflation rates for the different inflation-linked securities on offer. For each bond, this is the average annual inflation rate implied over the life of the bond by the difference between the inflation-linked bond’s real yield and the yield on a fixed rate bond of a comparable maturity. Taking this a step further, if an investor believes that the actual inflation rate will be higher over the period than the break-even rate implies, he or she should buy the inflation-linked bond at the expense of the fixed-rate bond. If the reverse is the case (i.e. the inflation rate is expected to be lower than the break-even rate) then the fixed-rate bond should be preferred.

As at 11 December, and using data from the Financial Times website, here is a table of real yields and break-even inflation rates for some benchmark inflation-linked bonds.

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