WOULD INFLATION-LINKED BONDS SURVIVE AN INFLATIONARY DEFAULT? / THE ECONOMIST

Would inflation-linked bonds survive an inflationary default?

A thought experiment on the nearest thing to a safe asset

Illustration: Satoshi Kambayashi

Perhaps the biggest headache for any investor is that no asset offers complete safety. 

Inflation gnaws away at cash; gold might offer protection but its price has soared so high that it feels less like insurance than chasing a hot trade. 

Rich-world government bonds are supposed to be havens, and have historically done better than cash at outpacing consumer prices. 

Just now, though, plenty of governments are borrowing so much that it is worryingly easy to imagine them letting the money-printers whir and inflating away their debt.

These are the sorts of worries that might lead you to inflation-linked bonds (or “linkers”), which offer payments that rise along with consumer prices. 

Linkers were first issued by the Commonwealth of Massachusetts in 1780, during the American revolution, when they were pegged to a basket of goods featuring corn, wool and leather. 

They were then used to pay soldiers made mutinous in part by their paper money losing value. 

They are now issued by governments around the world, pegged to official inflation indices. 

Pension funds and insurers, with liabilities that often rise in line with these, are keen buyers. 

And for individual investors, linkers guarantee a future income stream with fixed purchasing power—useful for, say, planning a retirement. 

Though no asset is truly safe, these bonds come close.

How, then, would they fare if a debt-laden government let inflation rip? 

That scenario, as our special report argues this week, is more likely than often appreciated. 

One answer is that this is exactly the risk linkers exist to mitigate. 

A government that sells them, after all, cannot later stiff buyers by debasing its currency. 

The safety-valve has slammed shut, since the nominal value of the linkers, unlike that of other bonds, would rise with consumer prices. 

Take Britain, where linkers make up a quarter of the national debt. 

An inflationary default, by trashing the rest, would raise this quarter-share, spurring demand for new bonds to be similarly protected. 

The debt burden would be eased, but only up to a point.

Linker-holders should consider three other potential outcomes. 

One is that central banks buy their bonds, wrenching the safety-valve open, since in public hands they could be devalued. 

This is only imaginable in a world where central bankers have lost independence or shelved their inflation targets: it would amount to a public bet on runaway prices, and there are few worse signals they could send.

Britain’s share of inflation-linked debt is too low to warrant such a drastic measure; those of other rich countries are lower still (only 7% of American Treasuries are linkers, for example). 

Hence the second, more likely outcome is that linkers are left on the market and function as intended, preserving their owners’ purchasing power even as that of bog-standard bondholders falls. 

This is a cheery scenario if you are one such owner.

At the same time, the consequences would show how much of a migraine even the safest asset can induce. 

Analogously to normal bonds, the real yields promised by inflation-linked ones move inversely to prices. 

So they fall as demand rises, which it surely would if inflation was eating the value of other debt and linkers were protected. 

Retirees and insurers who had locked in the income streams they needed at previous prices would sit pretty. 

Yet those still saving to buy bonds to guarantee their liabilities would see that goal recede, as lower real yields raised the amount they needed to generate the same income.

The situation would partially mirror the years of near-zero (or negative) interest rates—but with the addition of unstable inflation threatening growth, employment and other asset prices. 

As savers struggled, even existing linker-holders sitting on windfall gains would face difficult choices. 

Once they had booked their gains, they would either need to commit to years of low real returns, or sell and take their chances in markets destabilised by a new, much more volatile economic regime.

In the third and most concerning potential outcome for linker-holders, the question of safety never really goes away. 

When developing countries restructure debts, foreign investors are loth to take losses from which local ones are exempt. 

Whatever their agreed terms, would investors in linkers fare any better if all other bondholders were being rinsed and lobbying furiously for the pain to be shared? 

It would depend on how politicians balanced immediate unpopularity with the long-term public interest. 

Nothing to worry about, then.