RISKS ABOUND WITH INFLATION-LINKED BONDS / THE FINANCIAL TIMES GLOBAL ECONOMY ( A MUST READ )

Risks abound with inflation-linked bonds

By Jeremy Siegel

Published: February 2 2011 12:53

Inflation-protected yields are important to both economists and portfolio managers. With the advent in 1997 of inflation-protected bonds in the US, dollar investors were for the first time able to hedge against inflation, a benefit particularly important to pensioners. Just before the US bonds were issued, I received a call from a reporter inquiring at what interest rate I thought that the very first US Treasury inflation-protected security (Tips) would be issued. My own historical studies showed that the long-term real return on US government bonds was between 3 per cent and 3½ per cent and this was the estimate that I offered.


Indeed this was the rate that investors required for these bonds and their yields remained between 3 per cent and 4½ per cent over the next five years. At that time inflation-linked yields in other countries, such as the UK (which has had inflation protected bonds since the early 1980s), also ranged from 3 per cent to 4 per cent. These healthy rates were not a surprise, since economic theory predicted that real yields should approximate real gross domestic product growth, which averaged between 3 per cent and 4 per cent at that time.


But recently the yields on these bonds have collapsed to levels that would have been unimaginable just a few years ago. Last October, the real yield on the US 10-year Tips plunged to 36 basis points (0.36 per cent), and the yield on the five-year bond actually turned negative.

A negative real yield means that investors are willing to buy investments that promise to pay off less than the inflation rate. Inflation-linked yields have also fallen dramatically in other countries, and the yield on the UK’s 10-year inflation-linked bond has fallen well below 1 per cent.

What has caused the unprecedented collapse of real yields round the world? One factor is central bank policies that have pegged short-term interest rates near zero while inflation is still positive. Another factor is slowing real economic growth: real GDP growth averaged over 3 per cent in the 1980s and 1990s but has fallen to about 2 per cent since 2000.

But these factors can scarcely explain the magnitude of the decline in real yields. Real GDP growth has only slipped about one percentage point and the near zero-interest rate policies of the Federal Reserve and the Bank of England cannot continue as long as the economy improves and commodity inflation heats up. The major reason for the dramatic drop in these real yields is the unprecedented – and in my opinion unwarranted – level of pessimism and risk aversion that has gripped investors since the financial crisis.


Purveyors of this pessimism stress that the future rate of economic growth in developed countries looks bleak. “New Normal” advocates like Bill Gross of Pimco maintain that economic growth will fall significantly as ageing populations unwind from the massive over-leverage accumulated prior to the crisis.


On the contrary, I believe that the long-term outlook is bright. The emerging economies, which contain most of the world population, are growing very rapidly. India and China are set to send more people into the middle class over the next twenty years than the middle class populations of the US and Europe today and Western companies will have access to these large growing markets. Furthermore, economic growth depends on rate of discovery, innovation, and invention, which economists call “technological change.” Technological change has by far the most important impact on long-term economic growth. The communications and internet revolution has brought more researchers together to collaborate on common problems than any other development in modern history. This will spur faster, not slower economic growth.


All this means that Tips investors should beware. Although Tips may compensate holders for future inflation, the interest rate that they offer is far too low to offset the risk of rising rates. Even when these securities yielded 4 per cent, this yield did not compare to the historical return on equities, which has averaged between 6 per cent and 7 per cent in the US and about one percentage point less in the UK. As economic growth recovers and real rates rise, the price of Tips will fall leaving Tips investors with large losses in the face of accelerating inflation.


If returns on stocks reach their historical average, the margin by which stocks will outperform bonds will nearly double from its historic 3 per cent level. Stocks are still reasonably priced at less than 15 times projected 2011 earnings in virtually every country in the world. Dividend-paying stocks, whose payment is well covered by earnings, should be the choice of the conservative investor. These stocks have not only offered inflation protection but have participated in economic growth. This strategy will give investors far better long-term protection against inflation than today’s low-yielding inflation-linked bonds.


Jeremy Siegel is the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania


Copyright The Financial Times Limited 2011.