Inflation-linked bonds

I believe so.

I searched “why does US issue inflation linked bonds”:
Today inflation-linked bonds are typically sold by governments in an effort to reduce borrowing costs and broaden their investor base.

2 thoughts

-Switzerland does not run the same government deficit as US. SNB does not need to offer inflation linked bonds to attract investors

-until recently SNB did not want to attract investors. SNB was intervening in exchange markets to sell CHF so as to keep CHF low and protect exports

p.s. I find it fascinating that in 2022 Q4 SNB intervened in FX market to buy CHF to hold up the FX rate and reduce import driven inflation. A 180 degree change! CHF would otherwise have declined vs. other currencies

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Another reason is that there is a social security system for old people, so you don’t have to create your own pension fund :joy: There were already comments saying that holders of Swiss government bonds are mostly institutional investors, mostly pension funds.

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So I was interested if ILBs (inflation linked bond) could diversify risk in a portfolio. But I didn’t understand how they work. That’s why I took pen and paper to do some basic algebra. After pushing variables the whole day, I found the following (corrections appreciated):

  • All maturities of ILBs get a one-time increase/reduction in price from unexpected inflation, because it wasn’t priced in and the whole inflation (including the unexpected part) is directly multiplying the face value. So an additional 2% give you about an additional 2%.

  • The longer the maturity of the ILB the more sensitive to changes in expected interest and inflation it becomes. The sensitivity to a percentage point change is about the same for both. Interest being slightly stronger if absolute interest is lower than inflation, and inflation being slightly stronger when it’s the other way around. Those changes can cancel each other out. If inflation rises unexpectedly and the central bank rises interest rates in lockstep, the price of the ILB stays nearly the same. If absolute inflation equals absolute interest and they change by exactly the same the price stays exactly the same.

  • You can therefore say that LILBs (long-term ILBs) predominantly change price if the difference between interest and inflation changes. If inflation rises against interest the price rises, and if inflation falls against interest the price falls. Compare with the better known LNB (long-term nominal bond), which is just an LILB that behaves as if inflation was always zero:

LILB Infla. + Infla. -
Inter. + 0 - -
Inter. - + + 0
LNB Infla. + Infla. -
Inter. + - -
Inter. - + +
  • Falling inflation with rising interest will do neither any good. This would probably happen if they try to rein in rampant inflation. Gold and stocks probably also don’t like this environment. Cash, short-term bonds or shorting LNBs could work. None of which are attractive long-term holds. Maybe managed futures, but I haven’t finished analyzing them.

  • A by-catch of this exercise was that, if the market expects 10% interest this year and 0% next year, the yield curve will show 10% for 1 year of maturity and 5% (≈ (1.10*1.00)^(1/2)-1) for 2 years of maturity. This is apples to oranges. If everything happens as expected you get your 10% the first year and 0% the next year, regardless of which maturity you hold. Else you could buy both and short the 2-year bond for one year and get 10% the first year and 5% the second year. Which is of course not how this is going to work. You might of course be additionally compensated for the higher risk of holding longer maturities (so a bit more than 10% the first year you hold the 2-year bond).

Assumptions for algebra:

  • P(n-1) * i(n-1) = P(n) - P(n-1) + F(n) * c
  • P(0) = F(0)
  • F(n-1) * h(n-1) = F(n) - F(n-1)

where:

  • P is the price
  • i is the expected interest rate for the comming year
  • h is the expected inflation rate for the comming year
  • F is the face value
  • c is the coupon rate
  • n is a year (reaching maturity at 0)

After a year the coupon is paid and afterwards a new price is calculated.

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The key problem is duration on ILB in Europe