A fresh lens on Inflation-Linked Bonds

STANLIB is the largest fixed-income asset manager in South Africa. While our clients may be aware of our core money market, income, and bond funds, they may not be as familiar with the exposure we can give them to Inflation-Linked Bonds (ILBs) or the role that ILBs can play as part of a well-diversified portfolio. 

 

This article discusses how this asset class can add value as part of a portfolio.

Robin Mulder

Robin Mulder

Portfolio Manager, LDI and ILB Funds

Over the three years to the end of June 2022, the total return delivered by South African ILBs, as represented by the JSE’s CILI index, outperformed headline CPI by 2.76% per year. Over that period the monthly return of the CILI has also been 90%-correlated to CPI, demonstrating the reliable protection against inflation that ILBs provide.

 

While the current spike in inflation can be attributed to specific phenomena (the fiscal and monetary response to the Covid pandemic and Russia’s invasion of Ukraine), we think that a more inflationary period lies ahead for the world. Some of the factors behind the benign inflation of the last 20 years, like globalisation, are fading or even reversing. War and politics are revealing the fragility of the global supply chains which connect consumers in developed markets with commodities and cheap labour in the emerging world. Investors seeking explicit protection against inflation would benefit from exposure to ILBs.

 

STANLIB’s Inflation Linked Bond Fund is a Regulation 28-compliant fund available to STANLIB’s institutional clients. The fund is suitable as an investment for investors in retirement annuities, pension funds and provident funds or as an allocation within a multi-asset portfolio. The fund has been the top-performing South African ILB fund over the last three, five and seven years (Alexander Forbes Manager Survey dated June 2022).

 

Investing successfully in ILBs requires strong quantitative skills, a deep understanding of macro-economics and technical market expertise. Our track record demonstrates that we have the necessary skills, while STANLIB’s status as the largest fixed income manager in SA gives us a structural advantage in executing strategies in the market.

 

STANLIB’s Fixed Income team seek to outperform their benchmarks and peer group through active asset allocation. At the beginning of 2022, their view was that ILBs were likely to outperform nominal bonds. As a result, STANLIB’s fixed income funds with appropriate mandates increased their exposure to the ILB fund. The team also identified an opportunity in longer-dated ILBs and increased duration within our ILB funds accordingly.

 

This positioning has rewarded our clients as inflationary expectations have risen. ILBs have outperformed nominal bonds with significantly lower volatility. In the 12 months to end-June 2022, the ALBI index (the top 20 largest and most liquid nominal bonds listed on the JSE) returned 1.25% while the CILI index (the top 15 ILBs listed on the JSE) returned 10.72%. We believe that ILBs offer a fixed income portfolio manager the benefit of diversification as well as an opportunity to add alpha.

 

What are ILBs?
ILBs are debt securities designed to help investors defend the purchasing power of their capital against inflation. They are primarily issued by national governments. ILBs are ‘indexed’ so that the principal and interest payments rise and fall in line with inflation. This means that an ILB will deliver a guaranteed above-inflation return if the bond is held to maturity.

 

The first ILBs were issued by the Commonwealth of Massachusetts in 1780 during the American Revolution. Much later, emerging market countries began issuing ILBs in the 1960s. The UK was the first developed nation to do so in the 1980s, followed by Australia, Canada, Mexico and Sweden. In January 1997, the US issued its first Treasury Inflation-Protected Securities (TIPS), and TIPS are now the largest component of the global ILB market.

 

ILBs in South Africa
The South African government issued its first ILB in March 2000. The R189 was a 13-year bond with a real coupon of 6.25%. Prior to the R189, inflation-linked debt instruments had been traded in the domestic South African market, but on an unlisted basis.

 

Initially, the South African ILB market was small and illiquid, but it has grown significantly over the past 20 years. The total value of South African government ILBs listed on the JSE is currently R760 billion, compared with R2.05 trillion of South African government-issued nominal bonds.

 

National Treasury remains the largest ILB issuer. It has ten issues outstanding, with maturities ranging from 2023 to 2050, and a total market capitalisation of R760 billion. Issuance of ILBs in the unlisted space continues but remains relatively small. National Treasury’s stated intention is for ILBs to represent 30% of total debt issuance.

 

State-owned enterprises and banks also issue ILBs in SA, but the government dominates the growing market as seen in Chart 1 below. This reality is reflected in the STANLIB ILB Fund’s portfolio allocation at the end of June 2022, when 83.4% of the fund was invested in South African government bonds.

 

The domestic market for ILBs has developed to such an extent that investors, especially retirement funds, can consider it a separate asset class within fixed income and allocate to it, alongside nominal bonds and cash.

 

Chart 1: RSA Government-issued bonds: market capitalisation over time

Chart 1
Source: Bloomberg

What do ILBs offer to issuers and investors?

 

ILBs should be regarded as an insurance policy for investors against the erosion of their purchasing power through inflation. As Chart 2 below shows, the purchasing power of rands in a savings account has declined by 40% over the last ten years. Other asset classes like equities have historically outperformed inflation but they do not offer explicit protection against inflation.

 

The insurance that ILBs offer investors represents an open-ended liability for the governments that issue them, since the principal that the government owes the investor increases in line with inflation. This differs from nominal sovereign bonds, the coupons and principal of which are fixed, helping governments to plan their finances. ILBs sound like a one-sided arrangement in the investor’s favour, so why do governments issue them?

 

Efficient markets create financial instruments that meet the needs of issuers and investors, and ILBs are a good example. Governments issue ILBs because they represent cheaper financing (initially at least) than nominal bonds, since investors will accept a lower real yield in return for the inflation protection that ILBs offer. Governments that issue ILBs are therefore betting on their ability to manage inflation successfully. The natural buyers of ILBs are pension funds that seek to protect the purchasing power of their investors’ capital at retirement.

 

Chart 2: Purchasing power of ZAR 100 deflated by SA CPI

Chart 2
Source: Bloomberg

How do ILBs work?
An ILB will always be explicitly linked to a measure of inflation, typically consumer price inflation, whereby the principal of the ILB will increase in step with price levels.

 

For example, consider a R1 000 20-year SA Government ILB issued with a 2.5% coupon (1.25% on a semi-annual basis). The principal value of the ILB will be adjusted upward over time in line with the relevant measure of inflation. Assuming that inflation is 4% during the life of the ILB, its principal value will rise from R1 000 at inception to R2 208 (4% per year, compounded semi-annually) at maturity. Investors owning an identical nominal bond would receive back less than half the capital that the ILB investors would be repaid at maturity.

 

While the ILB’s coupon rate is fixed at 2.5%, the rand value of the coupon payments will rise over time, since they are based on the inflation-adjusted principal value of the bond. The first semi-annual coupon would be R12.75 (1.25% of the inflation-adjusted principal of R1 020), while the final coupon will be R27.60 (1.25% of the inflation-adjusted principal of R2 208).

 

As with all listed bonds, the price of an ILB will trade up and down during its lifetime, but investors who plan to hold it to maturity can lock in their future return.

 

How do ILBs differ from nominal bonds?
Most government bonds are ‘nominal’, giving investors a fixed stream of coupon payments and then repayment of principal at maturity.

 

The theoretical price of a nominal bond is one that gives the investor a yield equivalent to the average expected interest rate over the life of the bond plus a ‘term premium’. The term premium can be thought of as the extra yield that an investor demands to lock up their capital in a long-term bond rather than rolling over a series of shorter-maturity bonds. We can think of this as compensation for the greater probability that a negative event will occur during the life of a 10-year bond than a two-year bond.

 

An inflationary surprise is one such negative event. Since price stability is an important part of a modern central bank’s mandate, an unexpected rise in inflation tends to increase the market’s expectations of future interest rates. Rationally, because the bond’s cashflows are fixed, its price must decline for its yield to keep track with the market’s increased expectation of average rates over the rest of its life. The fact that the market has been taken by surprise will also increase the perceived volatility of inflation, further increasing the term premium. The price of the bond will fall, creating a capital loss for the investor if they sell. If the investor continues to hold, they will receive a lower real yield than that available elsewhere in the market. If, on the other hand, inflation surprises to the downside (and interest rate expectations follow), nominal bond investors will enjoy a capital gain as the yield required by the market will fall and prices of bonds will rise.

 

Unlike nominal bonds, ILBs do not need to offer investors any extra yield to compensate them for the risk that inflation will surprise to the upside. The indexing function means that ILB investors are not exposed to the gains that nominal bond investors experience if inflation surprises on the downside. Pension funds are happy to give up those potential gains in return for the reassurance that runaway inflation will not destroy their clients’ purchasing power in the future. To these investors, ILBs’ structural hedge against inflation has significant value. Theoretically, the real yield on an ILB and matching nominal bond should be the same at any moment (since they will reflect the same market view of future interest rates and inflation). In reality, investors will accept a lower real yield on the ILB in return for the optionality of the inflation protection it offers.

 

In theory, the price of any financial asset is the present value of its future cashflows, discounted at an appropriate rate of return. The more distant the cashflow, the greater the change in its present value for a given change in the discount rate. Due to the fact that the principal of an ILB compounds through time, the bulk of an ILB’s cashflows occur farther in the future than on the nominal bond. In bond market parlance, this means that the ILB has a longer ‘duration’ than the nominal bond.

 

Given ILBs’ longer duration, financial market theory would expect an ILB to experience more price volatility than its nominal peer, but the reality is the opposite. Over the last five years, the ALBI index of nominal bonds has been almost twice as volatile as the CILI index of ILBs, with average 60-day volatility of 9.7% and 5.5% respectively. This paradox is explained by a difference in market structure: ILB investors typically hold to maturity whereas nominal bonds are more liquid and actively traded.

 

ILBs offer guaranteed returns over inflation which are found nowhere else in financial markets. Nominal bonds are structural losers in periods of rising inflation, and even equities offer only a limited hedge against persistent inflation. Companies’ sales and profits can be expected to rise in an inflationary environment, but this does not always translate into positive real returns for equity investors. As we have seen in the first half of 2022, equity markets fare poorly when central banks find themselves ‘behind the curve’ and are forced to depress aggregate demand to control inflation.

 

The value of insurance against inflation
ILBs give investors a way to incorporate explicit real returns into a portfolio, hedging the value of their capital against inflation. The value of guaranteed real returns has been highlighted by recent events. The world feels like a more unpredictable and inflationary place than it has for many years.

 

Inflation is the consequence of changes in the balance of demand and supply in the economy. Price stability is a delicate equilibrium which is easily threatened by domestic and external factors. For example, governments can increase money supply to deal with the consequences of their fiscal mismanagement, while global dislocations can throttle the supply of imported resources that the economy consumes.

 

Twenty years of globalisation have allowed manufacturers in developed markets to access cheap labour in emerging economies, keeping a lid on consumer prices. The disruption of the Covid pandemic revealed the fragility of global supply chains. It is likely that a period of ‘deglobalisation’ lies ahead, reversing some of that disinflationary benefit.

 

There are also structural forces which we believe will apply upward pressure to wages around the world. The US labour force contracted during Covid, and US employers are paying up, either to entice people to come back to work or to change jobs. China’s working age population started contracting in 2019, potentially reversing an important source of global disinflation over the last twenty years.

 

Meanwhile, Russia’s invasion of Ukraine is a reminder that Europe’s post-war peace is no longer a given, and China is challenging US hegemony in the Pacific. Access to commodities (and the ability to deny them to one’s adversaries) has always been a major aspect of geopolitical power and remains so today. Increasing tensions in the regions which produce the world’s commodities and the oceans across which they travel promise a period of higher and more volatile commodity prices.

 

Central banks, while notionally independent of government, are not always immune to the priorities of the country’s elected leaders. SA’s debt-to-GDP ratio was 69% in 2021 and is projected to exceed 87% in 2027. Given the country‘s structural headwinds to growth, fiscal consolidation is politically costly. Allowing inflation to boost nominal growth may be a more palatable way to halt the rise in the debt-to-GDP ratio before it undermines bond market confidence.
ILBs offer South African investors a way to protect their wealth against inflation and therefore a hedge against domestic and global uncertainty.

 

Have ILBs performed for investors?
Yes. As Chart 3 below shows, over the last 15 years the CILI index of ILBs has delivered a total return significantly above CPI. From March 2007 to March 2022 the consumer price index rose from a base of 100 to 221, while over the same period the total return of the CILI index rose from 100 to 311.

 

As mentioned above, the performance of an ILB over any given period during its life will be impacted by changes in its real yield. This can be a significant factor as the following chart shows. In the five years from 31 March 2015 to 31 March 2020, South African consumer prices increased by 27% but the CILI index only returned 8%. The underperformance of CILI against CPI is explained by the increase in the real yield (yellow line) from 1.73% to 4.8%, which is synonymous with a drop in ILB prices.

 

Chart 3: Cumulative CILI return and real yield vs SA GDP and CPI

Chart 3

The STANLIB ILB Fund

Chart 4 below shows the annualised volatility and returns over the last three years for each of the seven institutional ILB funds participating in the Alexander Forbes Bond Survey, the JSE indices for ILBs and nominal bonds and the average of the 26 nominal bond funds. The STANLIB ILB fund has achieved the highest risk-adjusted return of any fund in its peer group and outperformed both the indices and the average nominal bond fund.

 

Chart 4: Return vs risk over 36 months to end June 2022 (selected ILB fund peers in grey)

Chart 4

More insights