Tinkerbell, Loch Ness and Inflation-Linked Bonds

What are Inflation-linked Bonds and why are they so important in a de-risking framework?

by Shaun Levitan
Published July 13, 2015

The South African inflation-linked bond market is now just over a decade old. Whilst being one of the most widely misunderstood asset classes, it is unquestionably one of the most crucial investment opportunities available. Our featured article seeks to debunk two of the more common myths associated with it.

What are Inflation-linked Bonds and why are they so important in a de-risking framework?

Inflation-linked bonds provide investors with proceeds which increase with inflation during the life of the bond and hence protect investors from the effects of inflation. As such it is the only asset class that can be used to provide a guaranteed “hedge” against inflation.

Since pension fund liabilities are generally linked to inflation in some way, in the form of annual pension and salary increases, inflation-linked bonds form a crucial starting point in every trustee’s toolbox.

Interesting Fact: The British Government recognised the de-risking value of these bonds and restricted the initial issuance in 1981 to pension funds.

But aren’t inflation-linked bonds expensive?

The first listed inflation-linked bonds were issued in March 2000 at a real yield of over 6% per annum. Real yields have declined sharply since their introduction, reflecting the cheap levels at which they were originally issued. This yield compression was also due to the structural decline in inflation which emerged as a consequence of inflation targeting (in February 2000) and the improvement in South Africa’s credit rating (in 2005 S&P upgraded South Africa’s long term foreign currency rating from BB+ to its current rating of BBB+.

South African inflation-linked bonds are currently trading at real yield levels of approximately 3% per annum. Some people have naively commented that the asset class is expensive at these levels. Expensive? Expensive relative to what?

It is crucial to evaluate the price of inflation-linked bonds against an appropriate measure. For pension funds that measure is the liabilities that the investments are used to meet. A balanced fund manager may compare the price of an inflation-linked bond against a nominal bond of similar term as its measure. This could be done by deriving the expected inflation level (or breakeven inflation). Depending on his expectation of future inflation, he may then decide that one asset class is better than the other.

Colourfield Liability Solutions, as a Liability Driven Investment Manager, evaluates the bonds against its clients’ unique liabilities. Outperformance of the liabilities should be the only benchmark of concern for a fund. As the value of the liability is based on the prevailing yields on inflation-linked bonds, subjective views on the relative price of the instrument become irrelevant. If the appropriate portfolio of inflation-linked bonds is affordable, then they are the risk-free asset class for the fund, irrespective of how interest rates move or how inflation emerges. This is because the assets will track the liability and the investor’s objectives will be met. A decision to hold any other asset class can only result in an investment mismatch – this could cost the fund dearly if subjective views/models don’t pan out as planned.

Interesting Fact: US Inflation-linked bonds traded at real yields of 4% in 2000; fell to levels of 3% in 2002; were considered expensive when they traded at 2% in 2009 and are currently trading at just over 1% real. The UK long dated bond is trading at levels close to 0.5% real!

Inflation-linked bonds are illiquid – is it possible to use them as part of an ongoing strategy?

The issuance of South African inflation-linked bonds has increased exponentially since the first bond was issued. It is now possible for a fund to obtain a portfolio of R3 billion to R4 billion in weeks, rather than months.

This can be seen in the graph below which illustrates the market capitalisation of the market at the end of June in each calendar year. Auctions are now held weekly and on average R1 billion worth of linkers are issued. The size of the inflation-linked bond market has literally doubled over the last 2 years.

With a commitment of National Treasury to have about one third of issuances in these bonds, an announcement of a further two inflation-linked bonds this year and National Treasury committing to issue into the demand of the RMB Inflation-linked bond Exchange Traded Fund, the liquidity problem is less of a concern.

Interesting Fact: The US issued inflation-linked bonds for the first time in 1997, French were the first to issue in Euros in 1998 and the Japanese only issued these instruments as recently as 2004.


Colourfield Liability Solutions believes the starting point of any investment strategy is to construct the minimum risk portfolio of assets with reference to the liabilities. It is very likely that inflation-linked bonds will be the core asset of such a strategy. A decision to hold a mismatching asset should be as a result of trustees understanding the risk/return trade off of other asset classes and not due to incorrect or sensationalistic views on the expensive pricing of inflation-linked bonds or their “lack of liquidity”. These myths should remain in the story books with Tinkerbell and the Loch Ness Monster.

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