The Uneasy Truce Continues

How has the valuation of European inflation-linked bonds changed since the beginning of the year?
US ETFs tracking inflation-linked bonds (or TIPS) have attracted large inflows this year, and the iShares Barclays TIPS bond fund (NYSE Arca: TIP) has become the largest US bond ETF. You can find a review of this sector on our sister site, IndexUniverse.com. Most of the performance in the TIPS sector this year has come from shorter-dated bonds, while the real yield on longer-dated maturities has remained pretty static.

So how do things look in European inflation-linked bond markets?

As far as assets under management go, things are very different to in the US market. There are no inflation-linked funds in the top 15 European bond ETFs by size, with funds tracking money market rates and corporate and government issues occupying all the places.

As many commentators have remarked, it appears that continental European investors are less concerned about inflation than their American (or should I say Anglo-Saxon) counterparts.

However, where valuation and performance are concerned, similar trends can be seen to those we’ve witnessed in the US market.

Here are tables of the changes in real yields and break-even inflation rates for selected European government inflation-linked issues since the end of last year, taken from the data archive of the Financial Times website.

Real Yields
Inflation-linked bond 29/12/2008 (%) 27/08/2009 (%) Change (bp)
France 2.5% 2013 1.80 0.79 -101
Sweden 4% 2020 1.76 1.57 -19
UK 2.5% 2011 2.75 -0.62 -337
UK 2.5% 2016 2.03 0.91 -112
UK 2.5% 2024 1.61 1.07 -54
UK 2% 2035 0.79 0.66 -13


Break-even Inflation Rates

Inflation-linked bond 29/12/2008 (%) 27/08/2009 (%) Change (bp)
France 2.5% 2013 0.88 1.44 56
Sweden 4% 2020 0.80 1.99 119
UK 2.5% 2011 -2.18 1.54 372
UK 2.5% 2016 1.27 2.04 77
UK 2.5% 2024 2.35 2.85 50
UK 2% 2035 3.05 3.46 41


As in the US TIPS market this year, most of the action in real yields (which in turn drives price changes) has been in the shorter maturities. The first table shows that the biggest absolute changes in real yield have been in the UK 2011, UK 2016 and France 2013 bonds. In the UK, as in the US, the real yield curve has gone from being steeply downward-sloping to upward sloping, with the exception of the longest-dated 2035 bond. And, with the real yields on all these bonds now pretty depressed (even negative in the case of the shortest-dated UK issue), it’s hard to see much value at current levels. Long gone are the days when you could buy TIPS or UK index-linked bonds for real yields of above 4%! If expectations for growth remain low and demand for short-dated government debt stays in place, real yields may stay depressed for a while to come.

The break-even inflation rates in the second table are calculated by comparing the index-linked bond real yield with that on a conventional government bond of near maturity. These tell you how much annual inflation is discounted over the life of each bond.

As inflation-linked bond real yields have fallen this year, while conventional fixed-rate yields have risen slightly, the net effect has been to push up these break-even rates. The most notable change has been in the 2011 UK bond, for which we have moved from a situation where two to three years of falling inflation (at over 2% per annum) were being discounted, to the current discounted rate of 1.5% for two years. The further you go out into the future in the UK, the more inflation is discounted – up to around 3.5% over 25 years.

Whether you prefer fixed-rate or inflation-linked bonds depends on your view of inflation and if you think the actual turnout will be lower or higher than these break-even levels.

If the negative break-even rates that prevailed in November last year were a signal for many investors that it was a good time to buy inflation-linked ETFs, now the situation doesn’t seem so clear-cut, and if investors start to worry about deflation again there could be a shift back from inflation-linked to fixed-rate bonds.

As I wrote last month, this feels like an uneasy truce between the deflationists and those forecasting that much higher inflation is on the way. Only time will tell which side is right!

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