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The case for global index-linked bonds
Over the past two decades, index-linked bonds have become a familiar part of the investment landscape. In the UK, the first index-linked gilt was issued in 1981 while the US Treasury sold its first index-linked bond in 1997. In the last ten years, governments have stepped up their issuance of index-linked debt. As a result, the global index-linked bond market has more than doubled in size since 2003.
Three factors have underpinned investors’ growing demand for index-linked government bonds.
1. Unconventional monetary policy, growth and inflation
Under normal conditions, investors seek to protect their wealth against inflation by holding 'real' assets (such as commodities and property) or financial instruments with a claim on real assets (such as equities). Constrained by fiscal restraints and political considerations, policymakers have turned to unorthodox policies such as quantitative easing to stimulate growth. Monetary theory suggests that this will have implications for long-term inflation. Indeed, the prices of both hard and soft commodities have grown increasingly volatile in recent years, fuelling worries that central banks may start a long-term inflation problem.
Despite the application of monetary stimulus, the path toward economic growth for the world’s largest economies remains unclear. Some investors are worried that policymakers may succeed in triggering inflation even as they fail to deliver growth. As a result, many are turning to index-linked bonds to hedge their inflation risk. Because their payments to investors are adjusted in line with movements in prices, index-linked bonds can help protect capital against erosion by inflation.
2. Ageing populations and secular demand trends
The market’s appetite for index-linked bonds reflects more than a simple calculation (or fear) that prices will rise. Pension funds and other institutional investors must meet real (i.e. inflation-adjusted) rather than nominal liabilities. Furthermore, broader demographic trends, such as ageing populations across the west and a growing awareness of the dangers that unfunded liabilities pose to corporate balance sheets, mean that demand for index-linked bonds is likely to remain robust. Liability-driven investment (LDI) strategies have been particularly big buyers of index-linked bonds. To take just one highprofile example, more than 90% of the Bank of England’s occupational pension fund is now invested in index-linked securities.
3. Diversifying returns
The third factor underpinning demand for index-linked bonds is a desire to find sources of uncorrelated return, a task that becomes particularly urgent in times of uncertainty and market volatility. Index-linked bonds traditionally exhibit lower volatility than equities and other inflation-hedging investments such as commodities or currencies. Historically, global index-linked bonds have exhibited a low correlation with other major asset classes, although they do tend to be more correlated to conventional government bonds when interest rates are low. That makes an allocation to index-linked bonds a simple way to introduce non-correlated returns to dedicated bond portfolios and to wider, multi-asset investment strategies.