Are Inflation-Linked Bonds Attractive?

Yes. Inflation-linked bonds, particularly US Treasury Inflation-Protected Securities (TIPS), have become an attractive investment option, given elevated real yields and their unique diversifying characteristics. These bonds not only serve as a viable hedge against inflation but also enhance portfolio resilience in a variety of economic environments. These positive attributes make inflation-linked bonds a valuable component for portfolio diversification, particularly for buy-and-hold investors with significant exposure to real liabilities in today’s uncertain economic environment.

Real interest rates have increased substantially in recent years, making real yields offered by global inflation-linked bonds, particularly US TIPS, more attractive than they have been in a long time. The Bloomberg US TIPS Index had a real yield of 2.0% as of July 17, which has slightly decreased from its recent peak but is still over 300 basis points above its all-time low set in 2021. This is a substantial move. Consequently, real yields in the United States have approached the 65th percentile of their historical distribution, which ranks best among global peers. Additionally, ten-year real yields in the United States surpass the yield implied by the trend growth rate of the economy (a proxy of their fair value) by nearly 1 standard deviation—another indication that real yields are elevated.

With the rise in real interest rates, investors can once again consider inflation-linked bonds a viable inflation hedge. These bonds pay a real return plus inflation over their life, making them appealing for buy-and-hold investors with significant exposure to real liabilities. Their value diminished when real yields neared zero or turned negative and inflation remained muted, as was the case for much of the previous decade. Today, however, both real yields and inflation have risen, making the math for inflation-linked bond returns more favorable. At a minimum, inflation-linked bonds should return around 2% at maturity, assuming inflation is 0%, but they should return between 4% and 5% if the markets’ expectations about inflation averaging slightly above 2% prove correct, and possibly 5% to 6% if inflation exceeds expectations.

In addition to compensating investors for inflation over time, inflation-linked bonds should perform well in another inflation shock. According to our scenario-based return projections, commodities and inflation-linked bonds are the only two major asset classes we expect to have positive annual real returns in a scenario modeled on an inflationary environment like the 1970s, with 7% average inflation over the next three years. Unlike most other inflation-sensitive assets, inflation-linked bonds typically offer a real yield and lower volatility. They are also resilient in various economic scenarios, including typical deflationary shocks associated with most recessions. Because of these unique characteristics, inflation-linked bonds may provide more broad-based portfolio diversification benefits and superior long-run returns than other inflation-sensitive assets, such as commodities, in both nominal and risk-adjusted terms.

While there is a lot to like about inflation-linked bonds, they do have shortcomings. They tend to underperform other high-quality bonds, such as nominal Treasury bonds, over short periods when inflation falls and over time when realized inflation is below expected inflation. They also exhibit less liquidity and have faced pressure during previous periods of stress, such as in March 2020. Additionally, inflation-linked bonds are sensitive to rising real interest rates, which can partially offset their inflation benefit over short periods. This sensitivity led to their unsatisfying performance during the recent bout of inflation. However, higher starting real yields make this less of a headwind today. Based on our modeling, US TIPS would return 2.6% per annum over the next three years in a stylized scenario based on a repeat of the 2021–23 inflation shock—a marked improvement from the actual -1.3% per annum return they achieved from 2021 to 2023. Performance would be even better if the rise in real yields is less pronounced, given that they are not as depressed as they were previously. We would still expect inflation-linked bonds to underperform other inflation-sensitive assets in this scenario, as they tend to have a lower beta to inflation. Still, even though investors may not get the most bang for their buck in an inflation shock with inflation-linked bonds, they can feel confident that these bonds once again provided a reliable hedge against inflation and have outperformed other inflation-sensitive assets, usually with less volatility, in the long run.

Given their attractive real yields and unique characteristics, investors should consider inflation-linked bonds a valuable component for portfolio diversification in today’s uncertain economic environment. For buy-and-hold investors with significant exposure to real liabilities, these bonds provide a reliable hedge against inflation and have historically outperformed other inflation-sensitive assets with less volatility over the long term. In an era of heightened economic uncertainty, where inflation poses a potential risk, including inflation-linked bonds can enhance portfolio resilience and provide peace of mind.

TJ Scavone, Senior Investment Director, Capital Markets Research