The Inflation Risk Premium: Real Return vs. Nominal Bonds

Moving money from real to conventional bonds.

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896560_81423091In February 1991, the Bank of Canada and the Canadian Department of Finance issued a joint policy announcement that clearly approved an anti- inflationist monetary policy for Canada. The core Consumer Price Index (CPI) inflation target was set to be 3% in 1992, 2.5% in 1993 and 1994, and 2% in 1995. Ten months later, the Canadian Government acted upon this and began to offer Real Return Bonds (RRB). RRBs consist of bonds for which the principal is adjusted in response to changes in the CPI. Although the coupon rate of an RRB remains fixed, the actual interest payment rises as the value of the principal increases with inflation. In that manner, the purchasing power of every coupon and principal remains constant for the holding period of the bond. Because the government will pay the realized inflation over the holding period, regardless if it happens to be 2% or 20%, RRBs are viewed as an insurance against unexpected inflation for the investor. However, as is always the case with insurance products, the inflation insurance is not free. When the investor is buying an RRB over a conventional nominal bond, he is transferring the inflation risk to the issuer, but at the same time, he is paying a higher price (through a lower required return) for the RRB than he would have for the nominal bond. This premium is usually called the inflation risk premium (IRP).

The modified Fisher equation (1) shows that the required return (or yield-to-maturity YTM) on a conventional bond consists of three parts: the real return rate, the expected inflation rate over the life of the bond and the IRP. The last element compensates the investor for the risk of having a wrong expectation of inflation. In the case of the RRB, since the investors do not assume this risk, the required return only contains the first two parts.

E(Rnominal) = Yreal + E(I) + IRP            (1) E(Rreal) = Yreal + E(I)            (2)

Where :

E(Rnominal) = expected nominal return on nominal return bond

E(Rreal) = expected nominal return on real return bond Yreal = real interest rate E(I) = expected inflation IRP = inflation risk premium

Siegel and Waring (2004) explain the utility for an institutional investor with a liability linked or partly linked to inflation of combining real return bonds and nominal bonds to minimize surplus (asset minus liabilities) risk. Nowadays, the expected return of such a portfolio is relatively low. Consequently, adding value is necessary to achieve the required rate of return of the actuarial evaluations. Tactical allocation between nominal and real return bonds can be a source of added value. In that manner, the amount of money that an investor is expected to leave on the table (IRP) by purchasing an RRB instead of a conventional bond needs to be quantified. We contribute to this field of research along three dimensions. First, we provide a time-series estimation of the IRP figure priced in the Canadian bond market. Second, we formally test for the relationship between the IRP and the subsequent difference of returns between RRBs and conventional bonds. Finally, we implement different systematic decision rules for the allocation between real and conventional bonds. We find that the IRP provides significant economic benefits when tactically moving money from real to conventional bonds. Read the full paper here.

Natacha Lemaire, M.SC., CFA, is adviser, investment Policy advising, Caisse de dépôt et placement du Québec, Montreal. Jean-François Plante, M.SC., CFA, is director, investments, Caisse de dépôt et placement du Québec, Montreal.

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