The planned inflation-indexed bonds by the Treasury will provide investors with a new, U.S. dollar-denominated asset class.
Investors will, for the first time, have an investment that will both provide real income and maintain value based on purchasing power.
As anyone who has heard the term "efficient frontier" knows, an investment with attractive returns, low risks and low or negative correlations will get gobbled up by portfolio optimizers. Inflation-indexed bonds entirely displace nominal bonds which offer about the same expected return but with more risk and higher correlations. Further, if consideration is given to the character of one's liabilities, the Treasury inflation-indexed bond will be the riskless investment for those with inflation-sensitive liabilities much as the Treasury nominal bond is the riskless investment for those with fixed dollar liabilities. Inflation-indexed bonds should have an expected return that is equal to (or marginally higher than) conventional nominal bonds.
Besides playing an important role in investors' portfolios, inflation-indexed bonds will have other significant ripple affects. They will change how we all think of the markets, and how economic policies and risk are managed.
We no longer will think of bonds in the same way. Henceforth we will think of them as consisting of two parts, the inflation expectations and the real rate, and we will watch these two parts trade separately throughout the day. We will know precisely what the market is betting and we can bet against these expectations; the real rate will be traded explicitly and the inflation rate can be traded by spreading the nominal bond against the inflation-indexed bond.
Because inflation literally can be traded, it also can be hedged. Just as the credit market futures contracts created the hedging vehicles that allowed financial institutions to offer instruments such as floating- and fixed-rate mortgages and other forms of debt, U.S. inflation-indexed bonds will spur numerous forms of inflation-linked or hedging instruments. Additionally, with the Treasury issuing inflation-indexed bonds, it now is likely other countries will follow and those already in existence will gain liquidity.
Because of inflation-indexed bonds, currency traders will be able to deal in real as well as nominal exchange rates. Economists will be able to see, and thereby better understand, the effect changing conditions (e.g., growth, budget deficits and monetary policy shifts) have on real interest rates as distinct from inflation; misunderstandings such as not knowing whether interest rates are rising because of inflation fears or because money is too tight will not occur.
This will allow for better management of fiscal and monetary policies and lead to more stable and improved economic conditions. In short, the direct implications of the Treasury's move on investor portfolios are significant and the secondary consequences will be beyond our capacity to imagine. Let's look at some specifics.
The real yield on inflation-indexed bonds should be in the vicinity of 3.5%. While no one knows what the real yields of nominal bonds will be because future inflation is unknown, 3.5% compares favorably with what they were historically. The average real yield of nominal Treasury bonds was 2.7% since 1958 and 2.1% since 1926.
Inflation-indexed bonds will have a risk that is one-third to one-half that of nominal bonds of the same duration. The volatility of inflation-indexed bonds arises from changes in real interest rates (as the volatility of conventional bonds is due to changes in nominal interest rates). Because real interest rates are one-third to one-half as volatile as nominal interest rates, that translates into proportionally lower volatility for inflation-indexed bonds.
Since the 10-year issue the Treasury probably will first auction has a duration (or sensitivity to real interest rate changes) of about eight years, the standard deviation of returns may be low, about 4%. Also, the correlations of inflation-indexed bonds with conventional bonds and stocks will be low or negative (over intermediate to long-term time horizons). That is because stocks and bonds tend to perform poorly when inflation rises and inflation-indexed bonds tend to do well (and vice versa). A simulation shows that for a one-year period, inflation-indexed bonds would have been 0.78 correlated with inflation, 0.28 correlated with conventional bonds and -0.17 correlated with stocks. For a five-year horizon, inflation-indexed bonds would have been 0.94 correlated with inflation, -0.03 correlated with conventional bonds and -0.27 correlated with stocks.
For these reasons, when put into a portfolio optimizer, U.S. inflation-indexed bonds entirely displace both conventional bonds and less reliable inflation-hedge assets, such as real estate and commodities.
Ray Dalio is president and chief investment officer and Dan Bernstein is director of research of Bridgewater Associates Inc., Wilton, Conn.