Inflation-linked bonds for inflationary periods?

Interest rate versus inflation rate sensitivity

Nicolas Rabener

Nicolas Rabener Finominal

Inflation is the biggest issue facing the US and is more important to citizens than crime, health care, or immigration according to aPew Research Centre surveyfrom May 2022. Given inflation of close to 10% this year, this is unsurprising.

Unfortunately, the financial advice retail investors are receiving for dealing with inflation is often poor. For example, a recentForbes articlehighlighted five options, where the first one is investing in a high-yield savings account that pays up to 1.5% interest per annum. Inflation was 8.3% in August in the US, which implies a negative real return of 6.8%.

The second option recommended by Forbes was investing in inflation-linked bonds, which is also often referenced by professional investors. We previously noted in an article that these types of fixed-income instruments were not highly correlated with inflation as their principal amounts get adjusted to changes in the consumer price index with a delay.

In this research article, we will explore the performance of inflation-linked bonds in year-to-date 2022.

Performance of inflation-linked bonds

Investors can buy single inflation-linked bonds like Treasury Inflation-Protected Securities (TIPS) directly or via ETFs. We focus on three ETFs that provide exposure to inflation-linked bonds from the UK, European and US governments. These manage between $800m to $30bn assets and charge management fees from 0.09% to 0.19% per annum.

Given the high inflation in most countries in 2022, investors might expect inflation-linked bonds to have outperformed and have generated attractive diversification benefits for traditional 60-40 portfolios that fared poorly. The trends in performance were similar, especially for European and US inflation-linked bonds but none of these ETFs generated positive returns.

chart, histogram

Source: FactorResearch

Bonds are expected to lose value when inflation is rising as central banks tend to increase interest rates, which has happened in 2022. Inflation-linked bonds are considered diversifiers for such an economic scenario and are expected to perform well, but the UK ETF holding such securities lost 28% of its value in year-to-date 2022, despite inflation being above 10% in the UK, which is a truly abysmal performance.

It seems that the performance of inflation-linked bonds was uncorrelated to inflation in all three capital markets.

chart, waterfall chart

Source: FactorResearch

Long-term performance of US TIPS 

Contrasting the performance of inflation-linked (TIPS) and plain-vanilla government bonds in the US highlights a similar performance over the last decade. For the avoidance of doubt, TIPS are also issued by the US government.

We observe that TIPS performed significantly worse in 2013, where inflation decreased to 1.46% compared to 2.07% the previous year, but also outperformed in 2021 as inflation started rising given supply chain issues from the COVID-19 crisis. However, the performance in 2022 is surprising as inflation increased further, where investors would likely have expected significant outperformance of TIPS.

chart, histogram

Source: FactorResearch

Factor exposure analysis

In order to get a better understanding of the drivers of performance, we conduct a factor exposure analysis. We use two independent variables, namely the US 10-Year yield and US 10-Year breakeven inflation. The R2 is approximately 0.8, which means these two variables explain the performance of both types of fixed-income securities reasonably well.

As expected, the inflation-linked bonds had a higher beta to the breakeven inflation rate than plain-vanilla government bonds. Ignoring the time period around the COVID-19 crisis in 2020 where inflation-linked bonds briefly declined by 12%, the average beta was 0.15, compared to zero for government bonds.


Source: FactorResearch

Next, we highlight the sensitivity to US interest rates, where we observe that between 2013 and 2019 inflation-linked bonds had a lower beta, i.e. they were more sensitive to changes in rates than government bonds. From March 2020 onwards, the betas were almost identical.

Investors would likely have expected less interest rate sensitivity for inflation-linked than plain-vanilla government bonds, but it does explain why the former has performed as poorly as the latter. Stated differently, inflation-linked bonds are still bonds and are negatively impacted by rising interest rates, even if inflation was rising.


Source: FactorResearch

Further thoughts

Considering these results questions whether inflation-linked bonds should be considered as appropriate instruments for hedging against inflation. The Forbes article suggests stocks and a diversified portfolio as third and fourth options, however, these are generic recommendations that apply to all types of economic environments. Portfolios should always be diversified.

The final and fifth option is likely the most relevant as that includes commodities, which are the best hedges against inflation based on academic research. However, the long-term performance of commodities is negative and only occasionally do they generate attractive diversification benefits. Better is to get exposure to commodities via trend-following funds (CTAs), which benefit from inflationary as well as deflationary environments.

Nicolas Rabener is founder and CEO of FactorResearch

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