FINM 3008/6016 Applied Portfolio Construction Tutorial #7

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FINM 3008/6016 Applied Portfolio Construction

Tutorial #7 – Outline

On the course Wattle site can be found the file “Tutorial #7 - Analysis File.xlsx”. This file provides background information for the discussion.

This tutorial delves into the nature of inflation-linked bonds (ILBs). The payoffs each period on ILBs reflect, in essence, a real yield plus an additional payment to compensate for realized inflation either via the coupon, or adjusting the face value. If ILBs are held to maturity, the total return reflects the real yield on purchase plus an adjustment for inflation over the whole period. However, returns during any particular period (e.g. a month) reflect these payoffs, plus any capital gain/loss stemming from changes in the (real) yield on the security. This will impact the short-term ILB return. (Note: when we refer to “short-term” return we assume the ILB is not held to maturity. Instead, it is sold prior to maturity so the selling price, and therefore the return, will be impacted by changes in the real yield during the time in which the ILB is held.)

The analysis file contains selected monthly data on yields and returns for inflation-linked bonds (ILBs) and conventional bonds, as well as inflation and equity returns. The series that are provided reflect availability: they cover differing time periods, and span Australia, UK, US and global. Specifically, the file contains:

· A ‘SUMMARY STATS’ worksheet with selected statistics estimated from the data.

· A worksheet to help illustrate the workings of ILBs versus conventional bonds.

· A ‘Data’ worksheet containing various time series for Australia, UK, US and G7 or world; including yields and returns for inflation-linked and conventional bonds, realized inflation (Consumer Price Index) and equity returns. The series provided reflect availability, so that some data is missing or incomplete.

· Blank worksheets in which you may include charts.

For this tutorial, the bulk of the data analysis has been done for you, and we will be focusing on interpretation of the output. Nevertheless, there are some tasks that you need to do in order to complete the excel file. These tasks include the following:

1. Estimate the ‘break-even inflation rates’ for Australia, US and UK (shaded cells in Columns I, J and K of the ‘Data’ worksheet). Break-even inflation is estimated as the difference between conventional (nominal) bond yields and inflation-linked yields. It is a measure of the rate of inflation that would result in conventional bonds and ILBs generating the same return if held to maturity. The break-even inflation estimates that you generate will be approximate to the extent that the two bond series are imperfectly matched in terms of duration, coupon payments, etc.

2. Draw the following five charts:

(i)  ILB yields for Australia, UK and US (three series on one chart)

(ii) Conventional 10-year bond yields less realized inflation for Australia, UK and US (three series on one chart). This provides an alternative measure of ‘real interest rates’ to ILB yields.

(iii) Break-even inflation versus realized inflation for Australia (two series on one chart)

(iv) Break-even inflation versus realized inflation for UK (two series on one chart)

(v) Break-even inflation versus realized inflation for US (two series on one chart)

The output appearing the SUMMARY worksheet and the charts provide background to assist in addressing the discussion points appearing below.

Question 1: Discussion points

(a) What are the drivers of ILB returns?

(b) The difference between conventional and ILBs (the break-even inflation rate) is not necessarily a perfect measure of inflation expectations over the term of the bonds. What other factors might influence the gap between conventional and ILB yields, apart from expected inflation?

(c) To what extent can ILBs be relied upon to provide an inflation hedge? (Hint: Think about the influence of investment horizon. Also examine the relation between ILB yields and returns with realized and expected inflation shown in the data file.)   

(d) Are ILBs the closest thing on offer to a “risk-free” asset?