Navigating government bonds: Nominal bonds vs. real bonds

A real, or inflation-linked, bond is a bond whose coupons (income payments) and notional (capital value) both rise with inflation, whereas these are fixed in nominal bonds.

Both can be issued with any maturity, subject to market appetite, and therefore have a corresponding level of interest rate sensitivity. Changes in inflation will then cause differences in performance, which may be marginal in the short-term but potentially compound over time.

The past few years have been marked by a significant inflation shock, following several extraordinary monetary and fiscal responses to the Covid pandemic and made worse by the Russia/Ukraine conflict. This has all influenced the performance of real bonds relative to nominal bonds.

Between 2020 and early 2022 inflation-linked government bonds broadly outperformed nominal government bonds (see chart below). This was when large parts of major economies were closed due to the Covid pandemic. Inflation initially fell in 2020 but started to pick up in the US over the course of the year. It was only in 2021 that inflation broke through central bankers' 2% targets on both sides of the Atlantic.

However, for much of 2021, central banks were convinced this episode of inflation would be a ‘transitory’ phenomenon and would disappear as quickly as it arrived. This led central banks to resist increasing interest rates to tame inflation. The environment was one of increasing inflation (and inflation expectations) while expectations of central bank interest rates remained anchored.

Inflation-linked bonds, like all other bonds, fall in price when interest rates increase. The difference is that inflation-linked bonds benefit from increasing inflation expectations, whereas nominal bonds do not. 2022 therefore represented the perfect environment for the performance of inflation-linked bonds, with inflation expectations increasing, but without the headwind of the expectation of higher central bank rates. It was only towards the end of 2021 in the UK and into 2022 in the US when central banks started to act and began increasing interest rates.

This demonstrates the frequently over-looked characteristic of inflation-linked bonds, which is that they are bonds first and foremost. As such, their prices have a negative correlation to changes in interest rates. Often inflation-linked bond prices are negatively correlated to interest rate changes than they are positively correlated to changes in inflation expectations.

While interest rates may be a key driver of inflation-linked bonds, it is inflation expectations (rather than headline annualised inflation) that is the other important driver of performance. So called ‘break even’ inflation rates, which is the difference between interest rates on nominal bonds and inflation-linked bonds with the same maturity, are the bond market’s best guess at inflation over a particular period in the future.

They are an important metric for choosing between nominal and inflation-linked bonds because if realised inflation turns out to be higher than the breakeven rate at the time of purchase, then the inflation-linked bond will outperform the similar nominal bond and vice versa.

Inflation-linked bonds being priced off inflation expectations, can lead to misunderstanding their behaviour – inflation-linked bonds might underperform even while headline inflation continues to rise if inflation expectations are falling.

One significant factor influencing the performance of inflation-linked bonds, particularly TIPS, is their correlation with oil prices. This close relationship between TIPS and Brent crude oil prices underscores the impact oil price volatility has on inflation expectations.

Despite elevated geopolitical tensions due to the conflicts in Ukraine and the Middle East, oil prices have broadly fallen over the last two years. Any further geopolitical instability could drive the oil price and inflation expectations higher. In this situation one advantage of TIPS is they would likely outperform nominal treasuries, and offer a hedge for investors.

Megatrends, the long-term structural changes that significantly impact societies, economics, and business, also affect inflation. Views on how they might impact inflation do vary.

When it comes to demographics and aging populations, there is evidence to support the view that it could be either inflationary or deflationary. However, the picture becomes clearer when looking at the trend towards deglobalisation and altered supply chains, which are likely to add to inflationary pressures.

The transition away from fossil fuels towards greener energy requires significant investment and this is why it is expected to be bumpy, which could be inflationary. The technological revolution, which incorporates robotics, artificial intelligence, and automation, should contribute to productivity gains and improved efficiencies, helping to reduce costs, which could be deflationary.

Inflation-linked bonds are first and foremost bonds, and their performance can be primarily driven by changes in interest rates, with changes in inflation expectations often the secondary driver.

While real bonds provide valuable inflation protection and diversification benefits, careful portfolio construction and asset allocation strategies are essential for navigating the complexities of government bond markets effectively. By considering the pros and cons of real bonds versus nominal bonds, investors can make more informed decisions and capitalise on opportunities.