Understanding Inflation-Indexed Bond Markets
48 Pages Posted: 22 May 2009
Date Written: May 1, 2009
This paper explores the history of inflation-indexed bond markets in the US and the UK. It documents a massive decline in long-term real interest rates from the 1990's until 2008, followed by a sudden spike in these rates during the financial crisis of 2008. Break even inflation rates, calculated from inflation-indexed and nominal government bond yields, stabilized until the fall of 2008, when they showed dramatic declines. The paper asks to what extent short-term real interest rates, bond risks, and liquidity explain the trends before 2008 and the unusual developments in the fall of 2008. Low inflation-indexed yields and high short-term volatility of inflation-indexed bond returns do not invalidate the basic case for these bonds, that they provide a safe asset for long-term investors. Governments should expect inflation-indexed bonds to be a relatively cheap form of debt financing going forward, even though they have offered high returns over the past decade.
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