Sandrine Soubeyran, Global Investment Research, FTSE Russell
As economies recovered from the Covid-19 pandemic, investors have rotated away from conventional government bonds and sought inflation protection in the reflation trade by switching into inflation-linked bonds. As a result, yields on inflation-linked bonds (IL) fell sharply. As can be seen in Chart 1, after an initial spike in March 2020, WGBI inflation-linked bond yields dropped to as low as minus three (in the 1-3-year area) and still remained well below zero in longer maturities.
Charts 1: Global WGBI real yields have fallen to three-year lows
Source: FTSE Russell, from December 31, 2019 to April 30, 2022.
Unlike real yields, nominal yields have risen sharply during the same period, pushing breakeven inflation to multi-year highs. Central banks had been more accepting of inflation running above-target levels during the pandemic, and there were fears this accommodative stance would extend during the war in Europe. Even so, the increase in value of IL bonds and the decoupling of nominal and real yields were unusual.
All change since 2022
However, since January 2022, real yields have mirrored the rise in nominal yields and become less negative. Chart 2 shows that inflation had already begun to build up in the second half of 2021 as economies recovered from exiting lockdowns. However, the impact of sanctions and the war in Ukraine drove energy and food prices to new highs. In response (and contrary to initial investor concerns), central banks signalled their inflation-fighting stance (including further quantitative tightening) and began the process of raising policy rates, which further pushed up nominal yields.
Chart 2: Global nominal yields are at their highest in three years
Source: FTSE Russell, from December 31, 2019 to April 30, 2022.
As a consequence, the biggest move came from the short end, where the yield gap between sovereign and comparable IL bonds (breakevens) have widened the most, followed by the 7-10-year area (see Chart 3). However, although inflation-linked bonds became relatively more expensive, as reflected by the higher breakeven levels, nominal rates increased even more. Like conventional bonds, inflation-linked bonds are affected by changes in interest rates. So even though inflation linked bonds have benefited from rising inflation, the price can be more than offset by the impact of rising interest rates as witnessed since Q1 2022.
Chart 3: Inflation breakevens rise to their highest levels since 2018
Source: FTSE Russell, from December 31, 2018 to April 30, 2022.
Rising interest rates impacted inflation-linked bonds returns
Consequently, returns for inflation-linked bonds have been broadly negative since January, as longer dated nominal yields have adjusted higher. As Chart 4 shows, short-dated IL bonds held up best in both April and since January, while their longer counterparts suffered the most, including double-digit losses in the UK and Germany.
Inflation-linked bonds are designed to help protect investors from the negative impact of inflation by contractually linking the bonds to a recognized inflation measure such as the CPI in the US. Therefore, their success relative to conventional bonds also depends on inflation expectations.
Chart 4. Longer maturities see the worst of the sell-off, both in April and YTD
Source: FTSE Russell, data as of April 30, 2022. Past performance is no guarantee to future results. Please see the end for important disclosures.
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