Wednesday 27 March 2013 by FIIG Research Legacy

An inevitable outcome: value of ILBs to be competed away

While equity returns provide access to growth in the underlying economy, they do not insure investors against variations in inflation. This brief study shows that long term data supports the premise that inflation and equity returns remain largely unrelated, and that one needs to ensure that the portfolio has adequate insurance against inflation. It seems likely that when investors recognize the value of inflation linked bonds (ILBs), as a form of portfolio insurance against inflation, it seems inevitable that current yields above inflation will fall; and fall substantially.

Equity return compared to inflation

Generally, equity returns do not have any definitive relationship to inflation. As Figure 1 shows, annual equity return, as measured by the S&P 500, varies around the annual inflation rate substantially, over a very long period.

One can try to more effective measure how equities might provide protection against inflation by looking at correlation analysis, especially the correlation between annual U.S. inflation and annual S&P returns. Correlation between two time series can be calculated with reference to a correlation coefficient. Correlation typically has a range between -1, which is a perfect negative correlation, and +1, which is a perfect positive correlation. Perfect negative correlation implies that the two time series move in opposite directions, whereas perfect correlation implies that both time series move together; either up or down in the same direction at the same time. If the correlation is 0, the movements of the securities are said to have no correlation.

As Figure 2 shows, correlation between annual equity return and annual inflation, in the U.S., varies substantially, and is generally more negatively correlated than positively correlated. However, the general conclusion is that there is no significant relationship between inflation and equity returns using this long term U.S. data. Such a conclusion is supported by other commentators, as the following quote indicates,

To sum up - if there is any relationship to reveal at all, it appears that inflation and equity returns are actually marginally negatively correlated. This should not be particularly surprising given the poor performance of equity markets during the inflationary 1970's, and subsequent strong performance since inflation has trended lower (Hamilton J., Jones, B., Suvanam, G., Challa, A., (2007), Australian LDI; Liability Driven Investment Has Arrived: Part 1, Deutsche Bank, 18 May 2007, pp.4-5).

Figure 2

As Figure 2 shows, the correlation has been negative for most of the period in question, which means that most of the time, the two times series tend to move in the opposite direction. Equities are driven by very different things other than inflation, especially expectations of growth, which remain notoriously volatile. Expectations dominate equity pricing as the earnings of companies remain difficult, or impossible, to effectively predict in perpetuity. Since equities provide perpetual access to the earnings of a company, the pricing of equities reflects variations in expectations of earnings over a very long period. This is why equities vary so much in price - as expectations move from optimistic to pessimistic, and from pessimistic to optimistic.

Given the significant volatility of equity returns, due to these serious and unavoidable difficulties in forecasting, one would expect that one would be rewarded in excess of inflation for assuming this risk. Such an expectation is generally correct, in that equities beat inflation by about 4.5% over the period. More specifically, whereas equities return around 8.31% on an average annualised basis, since 1950 in this study, that return is around 4.64% over inflation. Hence, equities, over the longer term, deliver in the region of 4 to 5 percent above inflation.

Figure 3

As Figure 3 shows, a rolling 4.5% return, above inflation, as shown by the light blue line, is roughly equivalent to all the volatility in equity returns, as shown by the dark blue line when one summarises the data for over 70 years. In other words, investment grade ILBs with real returns around 4%, can provide a similar return to equities, yet in a much more stable format, and with a much more senior position in the capital structure; senior secured in most cases, which is the highest point of the capital structure, as opposed to equity which sits at the bottom of the capital strucutre. Accordingly, ILBs provide an effective refuge from the raging storm of volatility that is provided by equity return, while also protecting investors against the risks of unexpected inflation. Instead of weathering the cycle of equity boom and bust, using ILBs seems to be a much more effective way of achieving return targets above inflation, while much more effectively protecting against unexpected inflationary surges and falls.


As we indicated last week, inflation needs to be taken seriously in the construction of portfolios, and this brief study shows that ILBs can provide an equivalent return to equities relative to inflation, without all the volatility which equity investors encounter. One might wonder why one would assume all the risk of equity investing, especially the risk that inflation erodes the value of saving, when ILBs provide such an effective alternative. Risks to inflation still remain very important to consider, as was indicated last week, and ILBs have a crucial, and hitherto largely unrecognized, role to play in terms of insuring the portfolio against inflation.

As investors become aware of the value of this inflation insurance through ILBs, the current yield above inflation, of around 4%, is likely to fall, as demand inevitably exceeds the supply of ILBs. In other words, the underlying value that currently exists in ILBs will lead to higher and higher prices, and those who move first, and purchase these securities, will benefit most.

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