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Financial Analysts Journal
Volume 68 Number 5
2012 CFA Institute
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Emerging Market Inflation-Linked Bonds
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Financial Analysts Journal
Figure 2 shows the relative amount of inflation- important differences between these two indices.
linked debt for each emerging market, measured by First, the bonds in the nominal and inflation-linked
th total face value of inflation-linked debt issued indices might not be equally liquid. Second, invest-
by these governments. We can see that Brazil is by ing in inflation-linked bonds, in principle, has the
far the largest issuer, with close to 50% of the total same credit risk as investing in nominal bonds
amount outstanding in 2011. Investors that follow a issued by the same government. Nevertheless,
market capitalization-weighted emerging market investing in inflation-linked bonds involves addi-
inflation-linked bond index should take into tional credit risk because the cash flows are paid
account that they have a large exposure to Brazil.5 later in the bonds' lives owing to the inflation uplift.
To prevent this large exposure from dominating my Third, investors' net return is influenced by the tax
results, I analyzed each country separately. treatment of nominal versus inflation-linked
Table 1 reports the descriptive statistics from bonds. Tax differences could arise because of dif-
my emerging market dataset, which includes total ferences in investor status (e.g., private versus insti-
returns, in local currencies, on inflation-linked tutional) or because of bilateral country tax rules.
bonds, nominal bonds, and equities for various For example, in countries where investors are taxed
countries. So-called comparator bond indices are on coupon payments and not the notional amounts,
available for several countries. Created by Barclays inflation-linked bonds are attractive because of the
Capital as a way to compare investing in nominal lower coupon and higher inflation-adjusted princi-
bonds with investing in inflation-linked bonds, pal. In countries where the inflation uplift is taxed
these indices contain government bonds with in the year it accrues, investors might find it disad-
maturities similar to those of the bonds in the vantageous to be taxed yet not receive any payment
inflation-linked bond index and with the same from the inflation-linked bond. Although taxes
index weights as the bonds in the inflation-linked might affect the prices of bonds, I did not take these
bond index. This feature makes them close substi- differences explicitly into account in my analysis.
tutes for investors who want to compare the per- For those countries for which no comparator
formances of nominal and inflation-linked bonds. bond index is available, I used index data provided
However, investors should be aware of several by J.P. Morgan. Argentina was the only country for
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Emerging Market Inflation-Linked Bonds
which I was unable to find an appropriate index to returns) between 5% and 10%, whereas equity mar-
compare nominal and inflation-linked bonds. For ket volatilities are typically larger than 20%. No
the local equity markets, I used country indices clear pattern exists that would suggest that
provided by Morgan Stanley Capital International inflation-linked bonds are more or less risky than
and obtained these series through Thomson nominal bonds as measured by the volatility or
Reuters Datastream. Note that Table 1 contains minimum return over one calendar month. Table 1
numbers calculated over different sample periods also shows that the average returns and volatilities
for each country. The existence of an inflation- are generally lower for developed markets than for
linked bond market determined the sample start- emerging markets. The budgetary problems in
ing date of the calculations. Greece have resulted in the lowest returns and high-
est volatilities.
Table 1 shows that the annual average local
return on bonds over the country-specific sample Table 1 also reports the average maturities of
period has ranged considerably among the coun- the nominal and inflation-linked bond indices.
tries. For example, annual average bond returns in Many inflation-linked bond indices have maturi-
Chile and South Korea have been close to 5%, ties close to 10 years, reflecting the desire of long-
whereas annual average bond returns in Argentina term investors to be protected against inflation
and Turkey have exceeded 20%. For all countries risks. Turkey is the exception, with an average
except Turkey, equity returns have exceeded bond maturity of less than four years for its inflation-
returns, albeit with substantially higher volatility. linked bonds. Among developed markets, Canada
Most bond indices have volatilities (measured by and Greece have the longest average maturities,
the annualized standard deviation of monthly close to 20 years.
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Financial Analysts Journal
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Emerging Market Inflation-Linked Bonds
From Table 1, we can also see the difference in matched alternatives that are attainable investment
average realized returns between nominal and portfolios. One should be careful with respect to
inflation-linked bonds. The difference between the some countries because the sample starting dates
two can be interpreted as the inflation risk pre- for nominal and inflation-linked bonds are not
mium. Although the magnitude of the inflation risk always the same. When the inflation risk premium
premium is difficult to determine empirically, it is is positive, the average returns of inflation-linked
generally estimated to be around 0.5% to 2.0% a bonds should be lower than those of matched nom-
year (see, e.g., Bekaert and Wang 2010). The nomi- inal bonds. Over the sample period under consid-
nal and inflation-linked bond indices do not have eration, the inflation risk premium for most
exactly the same characteristics but are closely countries, whether developed or emerging, has
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Financial Analysts Journal
apparently been negative and close to zero because through Thomson Reuters Datastream.7 We can see
the average return of inflation-linked bonds has that some countries have had relatively stable and
been somewhat higher than that of nominal bonds. low inflation rates. For example, Mexico's inflation
Even though the set of emerging markets is more rate was close to 5% for the entire sample period.
prone to inflation risks than are developed markets, Other countries experienced large fluctuations in
I found little empirical evidence of the existence of inflation rates over this relatively short period. For
a positive inflation risk premium. Theoretically, the example, inflation in South Africa was below 1% in
size of the risk premium of an asset class should 2004 and close to 15% in 2008, declining to below
depend on the covariance with the stochastic dis- 5% in 2010. The pattern of Chile's inflation is similar
count factor. An inflation risk premium would be to that of South Africa's, although it peaked close
consistent with inflation-linked bonds paying off in to 10% in 2008 and had a period of deflation in 2009.
bad economic conditions. Therefore, when the total The differences between inflation rates in
wealth of a country goes down, the return on an emerging markets are substantially larger than
inflation-linked bond should be positive. those in developed countries that issue inflation-
The average differential return between the linked debt. The inflation rates of developed mar-
nominal and inflation-linked bond indices is -1.5% kets are shown in Figure 4. These cross-sectional
a year for emerging markets and 0.4% for devel- differences in inflation movements can be used to
oped markets. Although the sample period is short, extract valuable information on countries that have
my results do not seem to support the existence of historically experienced stable inflation but that
a larger inflation risk premium for emerging mar- might experience higher and more volatile inflation
kets. One of the reasons for a relatively low differ- in the future.
ential return between nominal and inflation-linked
bonds could be the relative illiquidity of inflation- Diversification Benefits for Local
linked bonds compared with nominal bonds. The
existence of an illiquidity premium would increase
Investors
the required return on inflation-linked bonds (for a I investigated the value added by investing in
decomposition of U.S. and U.K. index-linked bond inflation-linked bonds for local investors in coun-
returns into inflation risk and illiquidity premiums, tries that have issued them. Bodie (1990) suggested
see Pflueger and Viceira 2011). Another possible that (privately issued) inflation-linked bonds are an
reason for return differences could be the higher attractive asset class for such long-term investors as
credit risk an inflation-linked bond investor is pension funds.8 Hunter and Simon (2005) and Brire
exposed to because the cash flows of such bonds and Signori (2009) found little empirical evidence
are more back-loaded. Also, differences in tax treat- that inflation-linked bonds add value to a portfolio
ment could affect the relative pricing of nominal of nominal bonds and stocks.9 However, they con-
and inflation-linked bonds. sidered only developed markets with relatively low
One reason for investors to shy away from and stable inflation rates. I explored whether
inflation-linked bonds is that their value depends inflation-linked bonds add more value for investors
on figures from the consumer price index as who face higher and more volatile inflation rates.
reported by the national statistics office. For some Assuming constant real yields implies that
countries, especially emerging markets, investors when nominal yields change, that change is caused
may worry about the independence of both the fully by changes in break-even inflation. Break-
national statistics office, which calculates inflation even inflation is the difference between the nomi-
rates, and the state treasury, which has to pay nal and the real interest rate on the same bond and
inflation-adjusted cash flows, potentially leading to largely consists of expected inflation, the inflation
compromised inflation rates. This governance risk risk premium, and the illiquidity risk premium.
must be taken into account and could lead to higher The correlation between nominal and inflation-
inflation risk premiums.6 linked bond returns is zero when real yields are
Table 1 also displays the characteristics of the constant. But when break-even inflation is constant
inflation rate in each country over the period when and nominal and real yields move alike, the corre-
inflation-linked bonds were available. The devel- lation between nominal and inflation-linked bond
opment of inflation over time is shown graphically returns equals 1. In the latter case, investors have
in Figure 3, which depicts the realized domestic no need to buy inflation-linked bonds because they
inflation rates that are based on the consumer price add no value to an investment portfolio.
indices of these countries. I obtained the inflation Table 2 reports the local correlations of nominal
series from the International Financial Statistics government bonds, inflation-linked government
database of the International Monetary Fund bonds, and equities. For ease of comparison, the top
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Emerging Market Inflation-Linked Bonds
rows concern the emerging markets and the bottom I proxied each country's wealth portfolio by adding
rows contain the numbers for developed markets. the total value of nominal bonds, inflation-linked
These asset classes are denominated in local curren- bonds, and equities. The wealth portfolios can vary
cies to represent the opportunity set of investors that substantially, depending on the development of
are willing or constrained to invest solely in their bond and equity markets in each country. Theoret-
home country. The correlations between nominal ically, the inflation risk premium should be related
and inflation-linked bonds vary substantially across to the covariance with the stochastic discount factor.
countries. This variation may depend on the differ- The correlations between the inflation-linked bond
ent periods under consideration as well as the infla- returns and the returns on the wealth portfolios are
tion regime and real interest rate changes in each also shown in Table 2. The relationship between the
country. For example, the correlation for Chile is observed inflation risk premiums and correlations
0.81, and the correlation for South Africa is 0.08. The between a country's wealth portfolio and inflation-
correlations between nominal bonds and equities linked bond returns is virtually zero. This finding
and between inflation-linked bonds and equities suggests that covariance with the country's wealth
also tend to be substantially different across coun- portfolio cannot explain the differences between
tries. For Brazil and Turkey, the correlations nominal and inflation-linked bond returns.
between inflation-linked bonds and equities are rel- Because inflation-linked bonds are designed to
atively high, at 0.48 and 0.51, whereas for Chile and protect investors from rising inflation, they are a real
South Africa, the correlations are slightly negative, fixed-income asset. Higher-frequency pricing of
at -0.11 and -0.14. These differences in ex post corre- inflation-linked bonds is influenced by inflation
lations may reflect the difficulty that investors face expectations rather than inflation realizations. It is,
when trying to determine the ex ante parameters on however, relevant for investors to know whether the
which to build their optimal investment portfolios. returns on investments in inflation-linked bonds
In examining whether inflation-linked bond move more in line with inflation than do their nomi-
returns are correlated with a country's total wealth, nal counterparts.10 Therefore, I investigated whether
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Financial Analysts Journal
Note: HICPxT represents the Harmonized Index of Consumer Prices excluding tobacco
Sources: Thomson Reuters Datastream; IMF International Finance Statistics.
the excess return of inflation-linked bonds relative to variance spanning, I used the regression frame-
nominal bonds is related to the realized inflation in a work of Huberman and Kandel (1987), further
particular country. I estimated the regression explained by DeRoon and Nijman (2001). For each
country, I estimated the regression
rILB _ rNOM =OL + pINFLt + e
to explore this matter in more detail. Table 3 reports *;=a + M/"0M+2*, + e,,
the estimation results for in this regression equa-
where RltLB , R^0M , and Rf are the total returns
tion at a monthly and quarterly frequency. A signif- on inflation-linked bonds, nominal bonds, and
icantly positive beta indicates that inflation-linked
equities, respectively, in period 1. 1 used Newey and
bonds are a better hedge against inflation risk than
West (1987) standard errors to correct for heterosce-
nominal bonds. Table 3 shows that the excess
dasticity and autocorrelation.
returns of inflation-linked bonds are indeed posi- I used a Wald test to check for the mean-
tively related to realized inflation for six of the eight
variance spanning restriction that a = 0 and i + 2
emerging markets at the monthly frequency and for
= 1. The p-values from this Wald test are reported in
all eight at the quarterly frequency In four cases,
the positive relationship is also statistically signifi- Table 2 in the column "Both"; the p-values of both
cant. For developed markets, the results are quali- restrictions are also shown separately. The mean-
tatively similar to those for emerging markets. variance spanning test is rejected for six of the eight
Thus, investors who are willing to protect their emerging markets. Thus, inflation-linked bonds
purchasing power are better off investing in added no value to a portfolio of domestic nominal
inflation-linked bonds than in nominal bonds. bonds and equities for only two markets: South
Korea and Mexico. Because South Korea's data
To test whether investing in inflation-linked
bonds improves the portfolio characteristics for series starts in April 2007, the sample period is prob-
investors, I conducted a mean-variance spanning ably too short to reject the null hypothesis of mean-,
test for each country separately. To test for mean- variance spanning. For Mexico, the high p-value is
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Emerging Market Inflation-Linked Bonds
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September/October 2012 www.cfapubs.org 47
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Financial Analysts Journal
Table 3. Correlations of Relative Returns of also due to the relatively high correlation between
Inflation-Linked Bonds with Realized inflation-linked bonds, on the one hand, and nomi-
Inflation Rates nal bonds and equities, on the other hand. For devel-
Country Monthly Quarterly oped markets, the null hypothesis of mean-variance
Brazil 5.2* 2.0*
spanning is rejected for 7 of the 11 countries. Overall,
Note: This table reports the beta estimates of the regression with
diversification benefits - drawn by Hunter and
a dependent variable (the excess returns of inflation-linked Simon (2005) and Brire and Signori (2009) - turns
bonds over comparable nominal bond returns) on a monthly out to depend heavily on the behavior of the real
and quarterly basis: r}lb - R?0M = a + INFLt + e,. interest rate in combination with the inflation regime.
*Significant at the 5% level. Their results do not seem to carry over to all other
markets that issued inflation-linked bonds.
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Emerging Market Inflation-Linked Bonds
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Financial Analysts Journal
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Emerging Market Inflation-Linked Bonds
Turkey 0.65* -0.13 -0.17* 1.27* 0.36* -0.10 0.29 0.00 0.01
EMGILB 0.73* -0.67* -0.10* 0.46* 0.38* 0.47* 0.00 0.00 0.00
EMGILB hedged 0.42* -0.21* -0.05* 0.44* 0.07* -0.06 0.00 0.00 0.00
Notes: This table reports the results from the mean-variance spanning regression:
REMLB = a + + hRDEVEQ + ^EMHOM + ^REMEQ + ^RDEVILB +
In addition to the parameter estimates, it also reports the p-values of three hypotheses. The first hypothesis is whether the intercept a
is zero, the second one is whether both s sum to 1, and the third is a joint test of the first two hypotheses, which is the mean-variance
spanning hypothesis.
*Significant at the 5% level.
Notes : The square on the solid line represents a portfolio with 81% emerging market inflation-linked
bonds, 17% developed market nominal bonds, and 2% emerging market equities. The circle on the solid
line represents a portfolio with 34% emerging market inflation-linked bonds and 66% emerging market
equities. The square on the dotted line represents a portfolio with 55% developed market nominal bonds,
35% emerging market nominal bonds, and 10% emerging market equities. The circle on the dotted line
represents a portfolio with 37% emerging market nominal bonds and 63% emerging market equities.
risk-return characteristics of investment portfolios. I tors in nominal bonds and equities should also allo-
also documented that inflation-linked bond returns cate a significant amount to inflation-linked bonds.
correlate more with realized inflation than do those Furthermore, my mean-variance spanning tests
of nominal bonds, even in the short run. Thus, inves- indicate that international investors who already
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Financial Analysts Journal
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Notes
1. See Bevilaqua and Garcia (2002) for arguments explaining (US$44 million as of 31 December 2010) and invests only in
why increasing the issuance of inflation-linked bonds by emerging market inflation-linked bonds.
the Brazilian government makes sense. See Barnes, Bodie, 3. The Barclays Capital indices do not cover some countries
Triest, and Wang (2010) for a complete scorecard on the that have issued inflation-linked bonds (e.g., Peru, Uruguay,
goals and objectives of issuing inflation-linked bonds. Iceland, and Kazakhstan), primarily because of the illiquid-
2. An exception is the HSBC Emerging Markets Inflation- ity and small size of their inflation-linked bond markets.
Linked Bond Fund, which was launched in June 2008 4. For a detailed description of the requirements, see James
(2010).
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Emerging Market Inflation-Linked Bonds
5. Arnott, Hsu, Li, and Shephard (2010) devised alternative 9. Eichholtz, Naber, and Petri (1993) reported a correlation of
weighting schemes for emerging market bonds - for exam- 0.5 between nominal and inflation-linked bonds for their
ple, using population, GDP, energy consumption, or the U.K. sample over 1983-1991. They also reported that the
square root of land area. Barclays Capital also offers indices correlation between wage changes and returns on inflation-
that constrain country weights. linked bonds is close to zero. Brire and Signori (2011)
6. For example, on 24 November 2010, the Wall Street Journal investigated strategic asset allocations for a Brazilian inves-
reported that "Argentina's government, in an unexpected shift tor faced with inflation risk.
toward economic pragmatism, said it was seeking technical 10. Chu, Pittman, and Yu (2011) thoroughly investigated the
assistance from the International Monetary Fund to design a reaction of U.S. inflation-linked bond prices to information
new inflation index that could help restore credibility to official around inflation announcement dates.
statistics" (see Matt Moffett and Ken Parks, "Argentina Asks
11. I did not consider international taxes in my analysis. In most
IMF for Help on Data/' http://online.wsj.com/article/
countries, international investors are exempt from paying
SB10001424052748704369304575633133553824108.html). Also,
taxes (or face a 0% tax rate if they are taxed). Nevertheless,
the Billion Prices Project (http:/ /bpp.mit.edu), launched by
some countries do impose taxes on foreigners who buy
Alberto Cavallo and Roberto Rigobon of the MIT Sloan School
of Management, has estimated substantially higher inflation
inflation-linked bonds. For example, Colombia levies a
rates for Argentina than the official inflation rate reported by
withholding tax of 4-7% on both income and capital gains
the Argentine government. for international investors. And Brazil has recently intro-
7. I used the consumer price indices with Datastream code duced a 6% tax for international investors who buy Brazil-
XXI64...F, where XX refers to the Datastream two-letter ian securities. In addition, some countries (e.g., Chile)
country code. Because this series is not available for Chile impose cumbersome trade settlement requirements.
until 2009, 1 used an alternative inflation series provided by 12. I also compared these results with the index in which bonds
Instituto Nacional de Estadsticas (Datastream code are not weighted by their market capitalization. Although
CLCONPRCF). these alternative indices might be better diversified from an
8. Other studies that have advocated the inclusion of inflation- ex ante point of view, their volatilities over the sample
linked bonds in investment portfolios are Lucas and Quek period are almost equal to that of the market capitalization-
(1998), Lamm (1998), and Roll (2004). weighted index.
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