Many investors have exposure to inflation-linked bonds, whether it’s within a diversified fixed income portfolio or a multi asset portfolio.
The difficulty is that inflation-linked bonds and conventional bonds behave differently. Inflation-linked bonds provide you with a real yield, whereas conventional bonds pay you a nominal yield. And nominal yields and real yields rarely ever move 1 for 1.
The consequence of this is that you can’t directly compare the duration of an inflation-linked bond to the duration of a conventional bond, and if you have inflation-linked bonds/funds within a broader portfolio, it is not straightforward to estimate what your overall duration position is. If you want to know how much interest rate risk you face, you have to make an assumption on how real yields will behave relative to nominal yields. This is called the ‘yield beta’.
Take index-linked gilts and conventional gilts as an example. The duration on FTSE’s conventional gilt index is 11 years, whereas the duration on FTSE’s all stock index-linked gilt index is about 23 years long. On the face of it, this would suggest that the conventional gilt index has half the duration of the index-linked gilt index, but this is misleading. In practice, the yield beta historically has almost always been below 1. In fact, if you assume that the yield beta is 0.5, which is a conventional rule of thumb (and generally wrong as per below), then the interest rate risk of the two indices is broadly comparable.
What yield beta should we assume?
A starting point is to examine the historical yield beta. Looking at the UK, we’ve plotted the yield beta of index-linked gilts over the last decade on the chart below, where we show 10 year conventional gilt yields versus 10 year index-linked gilt yields. Between 2007 and 2009, the yield beta for index-linked gilts was 0.39, meaning that for every 1 percentage point change in the yield of conventional gilts, the index-linked gilt yield would change by 0.39 percentage points. More recently the yield beta has increased, first to 0.70 in 2010-13, and over the last four years the figure sits somewhere around 0.85.
Yield beta of index-linked gilts vs conventional gilts
Source: Allianz Global Investors, Bloomberg, 05/01/2007-24/11/2017.Past performance is not a reliable indicator of future results
The yield beta can change much more than this however, particularly when driven by large changes in inflation expectations, and hence breakevens. We can break down the latest of the above periods into four distinct periods, which gives us very different yield beta assumptions for each. Underneath the chart below is a table detailing the yield beta for each period.
Source: Allianz Global Investors, Bloomberg, 07/06/2013-29/12/2017. Past performance is not a reliable indicator of future results
Source: Allianz Global Investors, Bloomberg, 07/06/2013-29/12/2017.
The period mid-2013 to mid-2016 saw index-linked yields move about half as much as conventionals. Then, following the Brexit vote, higher inflation expectations meant that breakevens increased and index-linked yields moved more than conventionals. Conventionals then sold off aggressively as UK gilt yields were lifted with global government bonds in the run up to and following the US presidential election. Since then, the yield beta has been around 0.7.
We also get a starkly different yield beta figure looking at some of the moves in 2008. Between August and November, the Global Financial Crisis was at its peak and breakevens got crushed as they fell from around 4% to below 1%. Conventional yields fell while index-linked yields increased. The yield beta over this period was -1.58.
Source: Allianz Global Investors, Bloomberg, 01/08/2008-28/11/2008. Past performance is not a reliable indicator of future results.
The yield beta can also vary along the curve. Yield betas tend to be lower for longer-dated bonds, and higher for shorter-dated bonds. This makes sense, as changes in the breakeven inflation rate should be higher for shorter dated bonds, since macro shocks (e.g. oil, GBP) are generally assumed to be temporary and assumed to have a bigger impact on short-term inflation expectations. Below are the yield betas calculated over 2017 for the 5, 10, 30 and 50 year parts of the curve.
The yield beta varies cross market too, in that it is not the same for UK index-linked gilts as it is for US inflation-linked Treasuries (TIPS). The US TIPS yield beta is shown in the chart below, and the table underneath provides the figures over time.
US inflation-linked Treasuries (TIPS) yield beta
Source: Bloomberg, 22/01/2010-31/12/2017. Past performance is not a reliable indicator of future results.
So what drives yield beta? In the UK there are a combination of factors which drive it, including oil, sterling, inflation expectations and issuance of index-linked and conventional gilts. In the US, the yield beta is primarily driven by oil, as demonstrated in the chart below.
Source: Allianz Global Investors, Bloomberg, 05/01/2007-12/01/2018. Past performance is not a reliable indicator of future results.
In conclusion, the yield beta assumption is critical to understanding the interest rate risk of a diversified portfolio that contains any inflation-linked bonds. Importantly, yield betas are almost always below one.
Yield betas are unstable, owing to changes in the drivers of nominal bond yields (i.e. whether a change in a nominal bond yield is driven by changes in the real interest rate or changes in pure inflation expectations). Yield betas also tend to vary across different countries’ inflation-linked bond markets, and even across different parts of the yield curve of an individual country’s inflation-linked bond market. They are also often driven by changes in variables such as the oil price.
Volatile yield betas introduce a non-negligible source of uncertainty when combining inflation-linked bonds in a diversified fixed income portfolio. But this uncertainty is also an opportunity; if yield betas were always constant and easy to calculate, then there would be zero benefit to owning inflation-linked bonds as part of a diversified portfolio!