On the Inflation Risks Embedded in Sovereign Bond Yields

Abstract

The purpose of this paper is to study the compensation for inflation risks priced in sovereign bond yields. And we do so by modelling the time-varying dynamics of asset returns and inflation, and then estimating the cost of hedging inflation risks from the perspective of a well diversified portfolio. This allows to disentangle the time-varying compensation for expected and unexpected inflation shocks embedded in sovereign bond yields; and provides estimates of the real risk-free rate. We show that nominal sovereign bond yields for Germany, France, Japan and the United States, reflect, over the more recent years, a low real risk-free rate, as well as low levels of compensation for both expected and unexpected inflation. The simultaneous occurrence of these low contributions is novel, and not encountered previously in our sample. We also find that inflation risks are not necessarily reduced with the inclusion of real estate assets in the minimum variance portfolio. Our analysis also prompts us to suggest that the financial advantage of issuing inflation-linked sovereign debt, and namely saving on the embedded inflation risk premium of issuing nominal debt, appears to be eroded by the liquidity premium charged by investors for holding the less attractive inflation-linked debt asset.

Keywords: inflation risks, portfolio choice, yields

JEL Classification: C32, E31, G11, G12