The slowly declining inflation, especially in the European Union, not only devalues incomes but also savings and investments. Although the capital market undoubtedly offers more attractive yields than the modest interest rates on savings (which have, however, risen above zero in most EU countries), the high inflation rate has prompted some member states to innovate.
For instance, Slovenia issued its first inflation-linked bond at the beginning of September, amounting to one hundred million euros with a real coupon of 0.825 percent, maturing in 2034. As stated by the Slovenian Ministry of Finance, the inflation-linked bond is a foundation for developing a new bond market aimed at a broader range of investors. – With this bond, we increase the diversity of instruments for financing the state budget and appeal to investors who invest in such debt instruments – they stated.
By issuing the first bond, whose principal is linked to the harmonized consumer price index for the euro area (Eurostat Eurozone Consumer Price Index – HICP ex tobacco), Slovenia joins a group of developed countries that already issue such bonds (Canada, USA…). Thus, when issuing inflation-linked bonds, Slovenia will not be exposed to inflation risk, as inflation is hedged; specifically, an interest rate swap has been concluded to manage interest rate risk due to inflation.
Given that inflation in Croatia is among the highest in Europe and there are no signs that it will fall quickly and drastically, the logical question is whether the state should refinance by issuing inflation-linked bonds instead of so-called national bonds? Because the difference for bondholders is not symbolic. For example, with inflation-linked bonds, the state indicates that it will pay a certain premium over the inflation rate, so if inflation is ten percent, and the state commits to pay two percent above inflation, that means the yield on the bond is twelve percent.
In the case of ordinary bonds, such as national bonds, if the state says it will pay, for example, four percent, that is the total yield. So if inflation is ten percent, that means bond buyers are effectively losing six percent (ten percent inflation minus four percent yield).
– Given that bonds pay a periodic and predetermined cash flow during their lifetime, most often annually or semi-annually, they are very vulnerable to rising inflation during that period. Namely, inflation will effectively reduce the yield on bonds in such a way that the periodic cash flow we receive and the principal repayment at maturity will be able to buy fewer goods and services compared to what we expected when exposing ourselves to the risk of purchasing someone else’s debt – explains Junior Fund Manager at InterCapital Asset Management Karlo Novosel, who adds that one of the proposed solutions is the so-called inflation-linked bonds or inflation-indexed bonds.
Yield 1.45 percent, but Real -3.95 percent
– An inflation-linked bond is designed in such a way that the coupon payment (periodic cash flow) and the principal repayment at maturity increase with rising prices in the economy. The simplest explanation is that as the cost of living increases, the return on inflation-linked bonds also increases. In a simple example, if we bought an inflation-linked bond with a nominal value of one thousand euros with a coupon of two percent and during its lifetime inflation increased to three percent, the nominal amount we receive at maturity will be 1,030 euros – one thousand euros plus three percent inflation. The two percent coupon we receive will now be calculated on the new base of 1,030 euros. In this way, we have protected ourselves from the erosion of the purchasing power of our cash flow.
Of course, inflation-linked bonds also have their drawbacks. They often offer a lower initial return than comparable conventional bonds, which we can understand as the cost of insurance against inflation. They are also less available and liquid, and due to their complexity, they may not be attractive to every investor. If inflation remains at the same levels, then we have the opportunity cost of a lower realized return. Finally, inflation-linked bonds are, by their nature, long-term, so they will not be suitable for short-term investors. Ultimately, the decision on which bond to choose will depend on what kind of investors we are, or how much risk we are willing to take for a potentially higher return – explains Novosel, providing a comparative calculation for national bonds.
A comparison of the accumulated yield of the national bond for investors and inflation (the harmonized consumer price index for Croatia) shows this: the national bond was issued on March 8, 2023, and if we look at the period until July 31, 2023 (145 days) for which we have available inflation data, the realized yield is 1.45 percent. In comparison, inflation during the period from March to July (including those months) rose by 5.4 percent. This means that the real yield for the holder of the national bond was negative, at -3.95 percent. Given the high inflation in the country, an inflation-linked bond would hedge and protect its owners from loss, so as long as it remains high, it would be advisable to follow Slovenia’s example.
