Last Updated on 27, April 2014
There was a question in Parliament on whether would the government consider issuing inflation-linked bonds for the retail market considering the low interest but high inflation environment. The full question and answer can be found at MAS website HERE.
The reply was that “MAS is studying the feasibility of such bonds. However, we have to recognize that market-pricing for an inflation-linked bond under the current very low interest rate environment could mean investors having to pay a large premium for such bonds. Furthermore, investors will suffer a loss should inflation fall below expectations.”
The following are my explanations on why this is so:
First, the word ‘premium’ means paying a high price. High price is associated with low return or even making losses. Assuming there are two identical bonds which are zero coupon bonds and years to maturity. But one of them is not an inflation linked and another is inflation linked. The answer why investors will have to pay a high price (premium) can be found in the following equation:
Nominal yield = real yield + expected inflation.
When we say the ‘interest rate’ environment is low, it meant that the nominal yield is low. But if the expected inflation is high, this implies that the real yield has to be negative so that the above equation holds. If the real yield is negative, it means that the investment is money losing. Another way of saying is investors bought the bond at too high of a price.
So is this mere theoretical? No, the low nominal yield and high expected inflation resulting in negative real yield for inflation-linked bonds is already happening for US treasuries of maturity between 1 to 10 years as explained in this article: Negative Real Interest Rates: The Conundrum for Investment and Spending Policies
Second risk mentioned by MAS is suffering a loss should inflation fall below expectation.
To understand this, consider the opportunity cost of buying an inflation-linked bond instead of non-inflation adjusted bond. Should inflation drop below expectation, the buyer of the non-inflation nominal bond is better of because the nominal yield is ‘lock-in’ or remains the same regardless of how inflation turns out to be as long as the bond is held to maturity. In fact, the buyer of nominal yield earns a higher real return because inflation was lower than expected. Therefore, the buyer of the inflation-linked bond is worse off if inflation drops below expectation.
However, if inflation rises above the expected inflation, the guy who buys the inflation-linked bond is the winner.
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