For example, a five-year nominal bond yielding 1 per cent, when adjusting for five-year expected inflation of 4 per cent, means real yields are negative 3 per cent. Put differently, an investor in nominal bonds with negative real yields is guaranteed to lose money in real terms over time.
Rising inflation and rising interest rates means nominal bonds are under pressure and will remain so for the medium-term. For so long as real yields remain negative, nominal bonds are guaranteed to lose capital value in real terms over time.
Interest rate risk and inflation-linked bonds
If nominal bonds do not protect against inflation, what about inflation-linked bonds? The clue’s surely in the name. Well it is, and they do. But you have to read the small print.
Inflation-linked bonds typically have very long duration, meaning they are highly sensitive to changes in interest rates. So while they provide perfect inflation protection if held to maturity (for example, 30 years), in the near-term, their capital value will materially decline as interest rates increase.
Inflation-linked interest payments will make up for this, if held to maturity. But if your time horizon for holding inflation-linked bonds is shorter than that, you risk experiencing a capital loss as interest rates rise and never recouping enough income thereafter to make up for it.
Any mismatch between duration (interest risk) and investor time horizons needs to be considered when designing portfolios.
What is duration risk?
Interest rate, or duration risk, measures the sensitivity of the inverse relationship between bonds’ value and interest rates. A bond’s duration provides a measure of how many years it takes for a bond investor to get the price paid for a bond from the bond’s total cash flows (interest and principal), so is measured in 'years'. The formal term is 'Macaulay duration'.
A bond’s value is sensitive to the interest rate used to discount its future cash flows back to today’s money. A bond’s duration can be used to measure its sensitivity (stated in years) to a 1 per cent change in interest rates, known as modified duration.
Whereas the duration of short-term (< five-year) gilts is approximately two years, for gilts it is approximately 12 years and for inflation-linked gilts it is approximately 21 years. Put differently, that means for a 1 percentage point increase in interest rates, that translates to a 21-year decline in capital value.
