The Bank for International Settlements has released its September 2008 Quarterly Review, filled, as usual, with many fascinating graphs, analysis and informational tidbits.
Unfortunately, this was released at a time when I am buried up to my neck with month-end duties, so I cannot review the articles thoroughly at this time. I have, however, scanned Peter Hördahl’s The inflation risk premium in the term structure of interest rates, as well as The ABX: how do the markets price subprime mortgage risk? by Ingo Fender and Martin Scheicher. Good stuff – I might have time to review them thoroughly next week – I might not – read it yourselves!
Other features, of less personal interest to me are
- The development of money markets in Asia, Mico Loretan & Philip Wooldridge
- Reducing foreign exchange settlement risk, Robert Lindley
as well as a review of international banking and financial market developments. In general terms, I heartily recommend reading these reports by international bodies because, unlike absolutely everybody else who will attempt to explain the financial world, these people are not trying to sell you anything – not even a copy of the daily newspaper. What bias they do have is limited to the occasional “regulation = good” reference.
Great link! I checked out the BIS article on inflation risk premia. It is interesting that past 5 years or so the US 10-year inflation risk premium (nominal yield – real yield – expected inflation) is close to zero, but currently 25 bp, while the Euro inflation risk premium is perhaps 20+ bp higher still.
Euro area inflation expectations are lower (1.9% now) than the US (2.5% now), yet there is a greater 10-year inflation risk premium for the lower inflation.
There are some subtle differences in the term structure of the inflation risk premium between the US and Euro area. It would have been interesting to see where Canada stacks up. Like the Euro area, we have an explicit inflation target and seem to have an inflation risk premium of about 50 bp.
Net net to an investor, it seems to me, is that nominal bonds are a better deal than real return bonds with 1.6% real return. Sure they are more risky, but we are rewarded with 25-50 bp of extra return. Also, small investors have a hard time buying real return bonds at low cost (mutual fund MER of 1.6% wipes out the real return and the XRB ETF has a 35 bp MER — at least 25 bp worse than outright purchases of nominal bonds).
it seems to me, is that nominal bonds are a better deal than real return bonds with 1.6% real return. Sure they are more risky, but we are rewarded with 25-50 bp of extra return.
I think this will usually be the case … the whole point of issuing RRBs in the first place is so that the issuer gets to keep the inflation risk premium, rather than having to pay it.
That being said, they can be a good addition to some portfolios anyway. For instance, the great enemy of perpetual preferred shares is inflation; some investors might wish to take a position in RRBs to mitigate that risk.
[…] I have not had a chance to read the BIS Quarterly Review article on inflation-indexed bonds with this conclusion firmly in […]
Pension funds in particular seem attracted to real return bonds (and the economic research literature is full of advice telling them this is the best match to their liabilities). But even at zero MER for large buyers, only the most conservative pension funds would hold more than a few percent of assets in such a low yielding asset — albeit inflation protected.
only the most conservative pension funds would hold more than a few percent of assets in such a low yielding asset
You might be surprised. In the ’90’s, a firm called JR Senecal (now Fiera Capital after a series of mergers) put all kinds of client money into RRBs … unfortunately, returns suffered in an environment of declining inflation expectations.
Oh, yeah. As at June 30, 2008, the CPP Investment Board has about 5% of total assets in RRBs … I don’t know whether “5” is more than “a few” or not!
few = not very many; a small number; a minority
a few is larger than a couple, so how about 3-9%?
As in “Preferred Shares yield a few percent in dividends with a bond equivalent yield a couple of percent higher than bonds (these days)”
😉
Also, I note that an INDEXED pension plan like teachers’ or CPP may be more inclined to hold more real return bonds as their liabilities grow faster with inflation for both working AND retired people. Non-indexed pension plans only have to worry about inflation in wages for the working staff until retirement. After retirement, payments are fixed.
So if CPP with 5% real return bonds is typical of indexed pension plans, then non-indexed plans might be lower.
Furthermore I’m not sure if there are enough real return bonds out there ($17B in 2003 to $25B??? or 10% of federal debt? now) to allow a pension fund average higher than 2-5 percent.