inflation-linked bonds

the nuts and bolts of xed income management

Introduction
Contents
What are inflation-linked bonds? .......................................................2 What are TIPS? ...................................................................................3 Comparing inflation-linked bonds and conventional bonds ...............4 Understanding breakeven inflation ....................................................5 Volatility in inflation-linked bonds ......................................................6 What are the potential benefits of inflation-linked bonds? ...............7 What are some of the main risks of inflation-linked bonds? .............8 Conclusion...........................................................................................9 Behind the industry jargon................................................................10 Learn more ........................................................................................11
Fueled by growing inflation concerns and attractive prices, particularly relative to nominal bonds, investors poured money into inflation-linked bonds in 2009. In the US, investors believe unprecedented fiscal and monetary stimulus will lead to more US dollar depreciation and higher inflation. In the UK, investors fear the Bank of Englands reluctance to raise rates will fuel inflation. While inflation has been muted in recent years, it remains a concern for pension funds, endowments and other institutional investors who must meet real, rather than nominal, liabilities. Inflation-linked bonds, such as US Treasury Inflation-Protected Securities (TIPS) and UK inflation-linked Gilts, can help hedge this risk because their principal is adjusted to reflect changes in inflation. In addition to the embedded inflation protection, these bonds offer other potential benefits to an investment portfolio. In this reference guide is an overview of the $1.5 trillion inflationlinked bond market, as well as a closer look at how these securities react to changing market conditions over short- and long-term periods.

This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.

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What are inationlinked bonds?

Inflation-linked bonds, sometimes known as linkers, are highquality securities issued mostly by governments that provide income and total return which adjusts to keep up with the pace of inflation. The global inflation-linked bond market has more than doubled in size since 2003 amid rising investor demand, and today there is also a fledgling market in inflation-linked corporate bonds. The UK was the first major market to issue these bonds in 1981, and they now represent approximately 23% of the UKs total outstanding debt. US TIPS assets have grown to $560 billion since they were first issued in 1997 and have been a key source of growth in the marketplace.1 Since their debut, inflation-linked bonds have generally performed as expected over long time periods; that is, they have moved in step with rising prices. Of course, because inflation-linked bonds are a relatively new investment, they have not yet had the opportunity to prove their mettle during periods of high inflation or hyperinflation.

What are TIPS?

TIPS represent the largest slice of the global inflation-linked bond market, and all these securities share the same general structure. The US Treasury issues TIPS in 5- to 30-year maturities. The principal is adjusted upward or downward each month based on changes in the Consumer Price Index (CPI-Urban, non-seasonally adjusted with a three month lag). The coupon rate remains fixed, but since it is applied to the inflation-adjusted principal, the semiannual interest payments increase or decrease accordingly. The chart below illustrates the structure of a hypothetical inflationlinked bond issued with a principal of $100 million, a coupon rate of 3% and a maturity of three years. The example shows what happens to the value of the principal and coupon payments when inflation in successive years is 2%, 3% and 0%, respectively.

Hypothetical Inflation-Linked Bond Structure

$105.06
Principal = $100 million

Inflation-Linked Bond Market at a Glance

Country
(year of first issuance)

$105.06

% Wgt of Total % Wgt of Total ($billions) Outstanding Debt ($billions)* Outstanding Debt

Total ILBs

ILBs

Total Nominal Bonds $4,154 $1,160 $1,125 $1,382 $5,101 $292 $1,214 $79 $317 $78 $14,902*

Nominal Bonds

$102 $100

US (1997) UK (1981) France (1998) Italy (2003) Japan (2004) Canada (1991) Germany (2006) Sweden (1994) Greece (2003) Australia (1997) Totals

$560 $353 $222 $132 $71 $42 $41 $35 $22 $10 $1,488

12% 23% 16% 9% 1% 13% 3% 30% 7% 12% 9%

88% 77% 84% 91% 99% 87% 97% 70% 93% 88% 91% Year

1 2% $3.06

2 3% $3.15

3 0% $3.15 $105.06

Inflation Rate Coupon Payments (at 3%) Redemption Value Total Cash Flows

$3.06

$3.15

$108.21

Simulated results do not reflect actual trading and have inherent limitations. Please see additional disclosures.

Source: Merrill Lynch, as of 10/31/09. *Excludes bills.

1

Source: Merrill Lynch, as of 10/31/09.

This information discusses general market activity, industry or sector trends, or other broadbased economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures.

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Comparing inationlinked bonds and conventional bonds

To understand how TIPS work, its important to note how their construction differs from traditional Treasuries. With a Treasury, the market prices in three sources of return: the real yield, an additional yield to compensate for expected inflation, and an inflation risk premium. The latter two components are the additional cost that buyers and sellers factor in to account for the uncertainty of inflation. By contrast, the return on TIPS has two sources of yield: the real yield and a yield representing actual trailing inflation. TIPS are unique in that their real yields are clearly identifiable, and they provide a predictable real return.
CONVENTIONAL BOND YIELDS Inflation Risk Premium Expected Inflation Rate INFLATION-LINKED BOND YIELDS Actual Inflation

Understanding breakeven ination

The difference in yield between inflation-linked bonds and conventional bonds, also known as the breakeven inflation rate (BEI), is a rough measure of inflation expectations. Breakeven inflation encompasses both the expected inflation rate and the inflation risk premium, two components of nominal yields that on their own are not always easily quantifiable. Put another way, breakeven inflation is the future inflation rate required for a real bond to achieve the same return as a comparable nominal bond, if held to maturity. If actual inflation is more than breakeven inflation, a real bond is likely to outperform the nominal bond. If actual inflation is less than breakeven inflation, the nominal bond is likely to outperform. Of course, in either scenario, a central bank may respond by lowering or raising rates to keep inflation in check. Breakeven inflation is only a rough measure because a number of factors can influence it, including liquidity and supply and demand.

Real Yield

Real Yield

Breakeven Inflation: the Markets Views on Rising Prices

CONVENTIONAL BOND YIELDS

For illustrative purposes only.

Inflation Risk Premium Expected Inflation Rate

INFLATION-LINKED BOND YIELDS

Breakeven Inflation

Actual Inflation

Real Yield

Real Yield

If actual inflation breakeven inflation

If actual inflation breakeven inflation

Conventional bonds may outperform

For illustrative purposes only. This information discusses general market activity, industry or sector trends, or other broadbased economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures.

Inflation-linked bonds may outperform

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Volatility in inationlinked bonds

A big issue for investors is that inflation-linked bonds are not always held to maturity. Real yields of inflation-linked bonds can and do change; they can be volatile just as the yields of conventional bonds are volatile. Real yields are influenced by many factors, including fiscal and monetary policy, supply and demand, liquidity and the level of economic growth. For this reason, inflation-linked securities can deliver positive returns when inflation is flat or even falling. For example, TIPS returned 13.9% in 2009 as of November 30 while CPI was down 0.2% year-over-year as of October 31. In the UK, inflation-linked Gilts returned 24.4%, with the Retail Prices Index (RPI) down 0.8% year-over-year, during the same time periods.2

What are the potential benets of ination-linked bonds?

TIPS and other inflation-linked government bonds have been hailed as a solid choice for pensions paying inflation-indexed benefits, endowments seeking to preserve purchasing power and other institutional investors whose task of asset/liability matching has grown increasingly challenging. Because they are issued by governments, they have minimal credit risk. They have less volatility than stocks and other inflation-hedging investments such as commodities or currencies. They also have a low correlation to major asset classes, although they are more correlated to nominal bonds when interest rates are low. Given their predictable real return, inflation-linked bonds may be a more reliable way to protect against inflation than equities, especially in cases of unexpected inflation.

Key Performance Drivers of Inflation-Linked Bonds

Economic valuation
Consistency of breakevens with inflation outlook in medium term Levels of breakevens relative to central bank inflation targets Levels of risk premiums associated with breakevens

TIPS: Low Correlation

Inflation-linked bonds have a low correlation to many other asset classes. S&P 500 MSCI EAFE Barclays US Aggregate 0.29 0.33 0.74 Barclays US High Yield
(2% constrained)

0.43 0.34

GSCI Commodities

Supply and Liquidity factors demand Risk appetites dynamics Supply and demand pressures on swaps Relative valuation Near term carry prospects
Relationship between breakevens and nominal yields Historical trading patterns Valuation of real yields and breakevens given near term inflation outlook and seasonality Effect on curve and levels of breakeven

Source: Bloomberg, 5-year correlation of Barclays U.S. TIPS Index as of 10/31/09.

TIPS: Less Volatility

TIPS have been less volatile than other asset classes over the long term but have demonstrated short-term volatility since 2008.
Annualized Standard Deviation (%) 35 30 25 20 15 10 5 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: Barclays, as of 10/31/09. US TIPS represented by the Barclays US Govt Inflation-Linked Bond All Maturities Index. Nominal bonds represented by the Barclays US Govt Break-Even Inflation-Linked Bond All Maturities Index, which provides a simple framework for comparing returns on an inflation-linked bond market with a nominal bond market. The Break-Even index includes nominal bonds that are maturity-matched with an inflation-linked bond index, which provides a much better comparison of relative performance than comparing a linker index with a conventional bond market index. GSCI S&P 500 US Nominals US TIPS

Source: Goldman Sachs Asset Management.

Source: Barclays. TIPS represented by the Barclays US Tips Index and UK linkers represented by the Barclays UK Inflation-Linked Index.

This information discusses general market activity, industry or sector trends, or other broadbased economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures.

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What are some of the main risks of inationlinked bonds?

Besides potential for short-term volatility, interest payments of inflation-linked bonds will decline in a deflationary environment, although investors in most countries will receive the full principal if they hold the bonds to maturity. For example, the US and France guarantee a deflation floor in which they will repay the initial par value at maturity, no matter what the inflation environment. Below are some of the other main risks of inflation-linked bonds: Index-based risk: The risk that the given inflation index mismeasures the actual increase in prices of goods and services that the bond holder is trying to hedge, or that the index computation will be altered in a way that is adverse to the interests of the bond holders. This can influence the breakeven rate in periods of very volatile inflation. Liquidity risk: Inflation-linked bonds are generally less liquid than comparable nominal bonds, which may raise real yields. Yield risk: Inflation-linked bonds may not perform as well in a rising interest rate environment. When a central bank starts raising rates, real yields are likely to rise and the prices of inflation-linked bonds are likely to decline.

Conclusion
Regardless of how inflation moves in the near term, history has shown that spikes in inflation can occur without warning, particularly after long periods of low inflation. Thus, the best time to hedge a portfolio against inflation can be before it starts rising. Investors looking to employ inflation-linked strategies in their portfolios should understand how these securities react to changing market conditions over shorter periods. Inflation-linked bonds have proved to be volatile over the near term, and positive performance may follow periods of low or negative inflation, and vice versa. An active manager can help identify the most attractive opportunities within this unique market segment and help mitigate issues with liquidity and cost.

This information discusses general market activity, industry or sector trends, or other broadbased economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures.

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Behind the industry jargon

Breakeven inflation

Learn more
Following is a list of GSAM publications that can help you further explore and expand your understanding of fixed income investing.

The difference between real and nominal bond yields, including both the expected inflation rate and the inflation risk premium. It is a rough measure of the markets inflation expectations.
CPI

Derivatives Mortgages, bank loans and structured credit Corporate credit Currencies Commodities

The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
Deflation

A sustained, broad-based decline in the price of goods and services.

Inflation risk premium Please contact your relationship management team to obtain a copy of these materials.

The additional yield that bond buyers demand to take on the risk of inflation.
Linkers

A general name for any bonds issued by governments whose principal and interest are adjusted to reflect changes in inflation.
Nominal yield

The yield of a conventional bond, which includes the real yield, the expected inflation rate and an inflation risk premium.
RPI

The Retail Prices Index (RPI) measures the level of retail prices in the UK.
Real return

The return on an investment that is adjusted to reflect changes in inflation.

This information discusses general market activity, industry or sector trends, or other broadbased economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures.

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