This article drills into a specific area of the bond market to examine how to find value in a world of low, or even negative, interest rates.

In the current environment of low interest rates, investors may be on the look-out for inflation-linked income. Meanwhile, the concept of duration is a topical one for fixed income investors given that it essentially measures how sensitive a bond's price is to interest rate movements. This article, by Jonathan Baltora, of AXA Investment Managers, explores dynamics and opportunities in the short duration inflation-linked bond space.

As always, the editors of this publication do not necessarily endorse all the views of guest contributors but are happy to share them and welcome responses.

The future of everyday bond portfolios should be considered in light of the impact of inflation, especially as interest rates remain low and inflation threatens returns. By linking bonds to inflation these risks can be offset as they increase in value during periods of inflation.

However, the decision isn’t just limited to inflation - the duration of the bond can have a significant impact on returns. Inflation linked bonds with shorter duration are less volatile and less sensitive to interest rate rises. Likewise looking at past performance, realised inflation and short duration inflation linked bonds are well correlated, meaning investors can capture realised inflation by buying short duration inflation linked bonds, while longer dated bonds will be more volatile. Furthermore short duration offers very good liquidity as they are essentially government bonds and therefore enjoy friendly risk weighting treatment on top of issue sizes usually being larger than $15 billion. Finally, the inflation rate paid out to investors is the same for each inflation linked bond from the same issuer. This suggests that investors willing to earn an inflation-linked income without the need for long duration may prefer short duration inflation-linked bonds.

With this in mind, it may come as a surprise to investors that short duration inflation linked bonds are in fact cheaper than their longer duration counterparts. The reasons for this are as follows. 

1)   The structural steepness of the inflation breakeven curve

As mentioned above, a key feature of inflation linked bonds is that whatever the maturity, the inflation rate paid to investors as part of the coupon is the same. This suggests that investors looking at inflation-linked income should simply aim to buy as low inflation breakeven as possible. As the inflation breakeven term structure traditionally has a positive slope, this means that short duration inflation-linked bonds are cheaper.

2)   The structural relative richness of long duration inflation linked bonds due to pension funds demand 

The preferred habitat theory suggests that the long-end of the curve is richer because of sustained pension fund demand. The nature of the buyers in a particular market gives opportunistic investors a picture of the structural supply-demand balance. Looking at both advanced and emerging economies the more local players there are on the buy side for structural reasons, the richer the market levels are. In the inflation linked bond market those players providing a recurring bid to the market are pension funds. This is a typical “preferred habitat” situation: because pension funds need long duration bonds to match their long-term liabilities, they tend to be less involved in short duration inflation linked bonds and concentrate on the back-end of the curve leaving opportunities for those able to buy short duration inflation linked paper.

3)   The anchoring of inflation expectations by central banks is making long maturities relatively stickier and less volatile

A key characteristic of today’s markets is the fact that central banks are commonly following an inflation targeting strategy. One of the objectives of this strategy is to anchor long-term inflation expectations. Looking at market gyrations one can easily see that the longer the maturity of an inflation linked bond, the lower the embedded inflation expectation volatility.

As an illustration, the US 2-Year inflation breakeven has fluctuated between 284 basis points over the past five years while the US 30-Year inflation break-even has been within a range almost two times tighter (119 basis points). We believe that this is evidence that inflation developments have more impact on the shortest maturities on the curve while longer ones are stickier and this can be seen by central bank’s commitment to inflation targeting. (Note: The break-even rate expresses the difference between the yield on a nominal fixed-rate bond and the real yield on an inflation-linked bond, such as a government bond.)