By Robin Marshall, director, fixed income research
Setting the context…inflation-linked protection is in demand
After central banks responded with substantial Quantitative Easing programs (QE), following the COVID shock in Q1 2020 and the beginning of the vaccine rollouts, demand for inflation-linked bonds has increased. In fixed income, investors have rotated away from safe haven government bonds, and sought inflation protection instead in the reflation trade, by switching into inflation-linked bonds. As a result, real yields on inflation-linked bonds have fallen since the end of October (despite the increase in nominal yields), and breakeven inflation (BEI) rates have risen, as Chart 1 shows for the US. Such decoupling of nominal and real yields is very unusual, and reflects the highly uncertain economic and financial regime, ushered in by the pandemic.
...and accurate breakeven inflation rates are key for investors and policy makers
For investors and policy makers alike, accurate breakeven inflation rates (BEIs) are important in measuring inflation expectations, in assessing the impact of monetary policy changes and measuring the relative costs of issuing either nominal debt or inflation-linked debt. There is evidence however, that BEIs are imperfect indicators of inflation expectations[1].
In addition to future inflation expectations, they may include both (1) a liquidity risk premium, and (2) an inflation risk premium. (In the UK’s case, there is the further complication of inflation-linked gilts being pegged to the retail price index until 2030, and the Monetary Policy Committee targeting the consumer price index.) Poor liquidity in inflation-linked government bonds may make it more difficult for index-tracking funds to adjust weights in line with market moves, and reduce the reliability of breakeven inflation rates.
Several research studies have found significant liquidity risk premium[2] in inflation-linked markets, both in developed (DM) and emerging markets (EM). In US TIPS and UK inflation-linked gilts, for example, these estimates have averaged out in the region of 25bp to 70bp, in the 10-year area. There is also evidence of a spike in bid-offer spreads and in liquidity risk premia in index-linked markets during periods of severe market stress, such as the global financial crisis in 2008/09 and the COVIDshock in 2020[3]. This may distort breakevens during these periods (see Chart 2). Furthermore, most studies have shown the liquidity risk premium to be notably higher in inflation-linked bonds than in nominal government bonds[4], in both DM and EM.
Increased central bank govt debt holdings may have also reduced market liquidity
After substantial QE, G7 central banks now hold a high proportion of outstanding government debt (as Chart 3 shows), reducing the “free-float” in government debt markets. This may have increased liquidity premia. The Bank of Japan, for example, now owns more than 50% of outstanding debt. The Bank of Canada has stated it does not wish to own more than 50% of outstanding debt, for fear of distorting the functioning of the market.
So it is important to incorporate elements of accessibility and liquidity into index design where possible…
These considerations, and the empirical evidence cited earlier, highlight the importance of market accessibility and liquidity as index inclusion criteria, particularly for inflation-linked government bonds. Thus, FTSE Russell recently announced the extension of its data-driven fixed income country classification process to inflation-linked markets, as well as refinement to market inclusion criteria to incorporate market size thresholds. This rules-based approach for global inflation-linked indexes, such as the FTSE World Inflation-Linked Securities Index, may help to reduce the liquidity premium for investors, since less liquid markets will be excluded from these indexes. They may also contribute to improving the accuracy of BEIs and make it easier for index tracking funds to reduce tracking error and get near to, or approximate, market index weights.
…to benefit investors and policy makers alike
These adjustments to managing local market inclusion should also ensure that the markets included in nominal and index-linked bond indexes are consistent with the scale of issuance between the two asset classes, implemented by the debt management offices. Using a consistent benchmarking approach for index inclusion across fixed income asset classes is designed to improve the quality of indexes, and benefit investors and policy makers alike.
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[1]See “The informational content of market based measures of inflation expectations derived from government bonds and inflation swaps in the United Kingdom”, Z. Liu, E. Vangelista, I. Kaminska, and J. Relleen, Bank of England Staff Working Paper, No.551, October 2015.
[2] See “Inflation Expectations and the News”, Michael Bauer (2015), International Journal of Central Banking, “Could the US Treasury benefit from issuing more Tips?”, Christensen and Gillen (2012), San Francisco Fed Working Paper 2011-16, “Tips from TIPS; the informational content of Treasury Inflation Protected Securities”, D’Amico, Kim and Wei (2014), Washington Fed Reserve, Finance and Economics Discussion Series, Paper 2010-19.
[3] See M. Andreason, J. Christensen and S. Riddell “The Tips liquidity premium”, December 2020, San Francisco Fed Working Paper, 2007-11.
[4] See “Inflation Expectations and Risk Premia in Emerging Bond Markets: Evidence from Mexico”, March 2021, San Francisco Fed, Working Paper, 2021-08.
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