A reference guide to inflation-linked bonds the nuts and bolts of fixed income managemen pdf

With a Treasury, the market prices in three sources of return: the real yield, an additional yield to compensate for expected inflation, and an inflation risk premium.. The difference in

inflation-linked bonds

the nuts and bolts of fixed income management

쐍 What are inflation-linked bonds? 2

쐍 What are TIPS? 3

쐍 Comparing inflation-linked bonds and conventional bonds 4

쐍 Understanding breakeven inflation 5

쐍 Volatility in inflation-linked bonds 6

쐍 What are the potential benefits of inflation-linked bonds? 7

쐍 What are some of the main risks of inflation-linked bonds? 8

쐍 Conclusion 9

쐍 Behind the industry jargon 10

쐍 Learn more 11

Introduction

Fueled by growing inflation concerns and attractive prices, particularly relative to nominal bonds, investors poured money into inflation-linked bonds in 2009 In the US, investors believe unprecedented fiscal and monetary stimulus will lead to more US dollar depreciation and higher inflation In the UK, investors fear the Bank of England’s reluctance to raise rates will fuel inflation While inflation has been muted in recent years, it remains a concern for pension funds, endowments and other institutional investors who must meet real, rather than nominal, liabilities Inflation-linked bonds, such as US Treasury Inflation-Protected Securities (TIPS) and UK inflation-linked Gilts, can help hedge this risk because their principal is adjusted to reflect changes in inflation In addition to the embedded inflation protection, these bonds offer other potential benefits to an investment portfolio

In this reference guide is an overview of the $1.5 trillion inflation-linked bond market, as well as a closer look at how these securities react to changing market conditions over short- and long-term periods

This material is provided for educational purposes only and should not be construed as

TIPS represent the largest slice of the global inflation-linked bond market, and all these securities share the same general structure The US Treasury issues TIPS in 5- to 30-year maturities The principal is adjusted upward or downward each month based on changes in the Consumer Price Index (CPI-Urban, non-seasonally adjusted with a three month lag) The coupon rate remains fixed, but since it is applied to the inflation-adjusted principal, the semi-annual interest payments increase or decrease accordingly The chart below illustrates the structure of a hypothetical inflation-linked bond issued with a principal of $100 million, a coupon rate of 3% and a maturity of three years The example shows what happens to the value of the principal and coupon payments when inflation in successive years is 2%, 3% and 0%, respectively

Hypothetical Inflation-Linked Bond Structure

What are inflation-linked bonds?

Inflation-linked bonds, sometimes known as “linkers,” are

high-quality securities issued mostly by governments that provide

income and total return which adjusts to keep up with the pace of

inflation The global inflation-linked bond market has more than

doubled in size since 2003 amid rising investor demand, and today

there is also a fledgling market in inflation-linked corporate bonds

The UK was the first major market to issue these bonds in 1981,

and they now represent approximately 23% of the UK’s total

outstanding debt US TIPS assets have grown to $560 billion since

they were first issued in 1997 and have been a key source of

growth in the marketplace.1Since their debut, inflation-linked

bonds have generally performed as expected over long time

periods; that is, they have moved in step with rising prices Of

course, because inflation-linked bonds are a relatively new

investment, they have not yet had the opportunity to prove their

mettle during periods of high inflation or hyperinflation

Inflation-Linked Bond Market at a Glance

Total Nominal

(year of first ILBs % Wgt of Total Bonds % Wgt of Total

issuance) ($billions) Outstanding Debt ($billions)* Outstanding Debt

Source: Merrill Lynch, as of 10/31/09 *Excludes bills

What are TIPS?

1 Source: Merrill Lynch, as of 10/31/09

This information discusses general market activity, industry or sector trends, or other

broad-based economic, market or political conditions and should not be construed as research or

investment advice Please see additional disclosures.

$100

$102

Payments (at 3%)

Total Cash Flows $3.06 $3.15 $108.21

Simulated results do not reflect actual trading and have inherent limitations Please see additional disclosures

To understand how TIPS work, it’s important to note how their

construction differs from traditional Treasuries With a Treasury, the

market prices in three sources of return: the real yield, an additional

yield to compensate for expected inflation, and an inflation risk

premium The latter two components are the additional cost that

buyers and sellers factor in to account for the uncertainty of

inflation By contrast, the return on TIPS has two sources of yield:

the real yield and a yield representing actual trailing inflation TIPS

are unique in that their real yields are clearly identifiable, and they

provide a predictable real return

The difference in yield between inflation-linked bonds and conventional bonds, also known as the breakeven inflation rate (BEI), is a rough measure of inflation expectations Breakeven inflation encompasses both the expected inflation rate and the inflation risk premium, two components of nominal yields that on their own are not always easily quantifiable

Put another way, breakeven inflation is the future inflation rate required for a real bond to achieve the same return as a comparable nominal bond, if held to maturity If actual inflation is more than breakeven inflation, a real bond is likely to outperform the nominal bond If actual inflation is less than breakeven inflation, the nominal bond is likely to outperform Of course, in either scenario, a central bank may respond by lowering or raising rates to keep inflation in check Breakeven inflation is only a rough measure because a number of factors can influence it, including liquidity and supply and demand

Breakeven Inflation: the Market’s Views on Rising Prices

Understanding breakeven inflation

For illustrative purposes only.

Inflation Risk Premium Expected Inflation Rate

Real Yield

CONVENTIONAL BOND YIELDS

If actual inflation ⬍

breakeven inflation

Conventional bonds may outperform

Actual Inflation

Real Yield

INFLATION-LINKED BOND YIELDS

If actual inflation ⬎

breakeven inflation

Inflation-linked bonds may outperform

Breakeven Inflation

This information discusses general market activity, industry or sector trends, or other

broad-based economic, market or political conditions and should not be construed as research or

Comparing inflation-linked bonds and conventional bonds

Actual Inflation

Real Yield

INFLATION-LINKED BOND YIELDS

For illustrative purposes only.

Inflation Risk

Premium

Expected

Inflation Rate

Real

Yield

CONVENTIONAL

BOND YIELDS

• Consistency of breakevens with inflation outlook in medium term

• Levels of breakevens relative to central bank inflation targets

• Levels of risk premiums associated with breakevens

• Liquidity factors

• Risk appetites

• Supply and demand pressures on swaps

• Relationship between breakevens and nominal yields

• Historical trading patterns

• Valuation of real yields and breakevens given near term

inflation outlook and seasonality

• Effect on curve and levels of breakeven

TIPS and other inflation-linked government bonds have been hailed

as a solid choice for pensions paying inflation-indexed benefits, endowments seeking to preserve purchasing power and other institutional investors whose task of asset/liability matching has grown increasingly challenging Because they are issued by governments, they have minimal credit risk They have less volatility than stocks and other inflation-hedging investments such as commodities or currencies They also have a low correlation to major asset classes, although they are more correlated to nominal bonds when interest rates are low Given their predictable real return, inflation-linked bonds may be a more reliable way to protect against inflation than equities, especially in cases of unexpected inflation

TIPS: Low Correlation

Inflation-linked bonds have a low correlation to many other asset classes.

What are the potential benefits

of inflation-linked bonds?

A big issue for investors is that inflation-linked bonds are not

always held to maturity Real yields of inflation-linked bonds can

and do change; they can be volatile just as the yields of

conventional bonds are volatile Real yields are influenced by many

factors, including fiscal and monetary policy, supply and demand,

liquidity and the level of economic growth For this reason,

inflation-linked securities can deliver positive returns when inflation

is flat or even falling For example, TIPS returned 13.9% in 2009 as

of November 30 while CPI was down 0.2% year-over-year as of

October 31 In the UK, inflation-linked Gilts returned 24.4%, with

the Retail Prices Index (RPI) down 0.8% year-over-year, during the

same time periods.2

Key Performance Drivers of Inflation-Linked Bonds

Volatility in inflation-linked bonds

Economic

valuation

Supply and

demand

dynamics

Relative

valuation

Near term

carry

prospects

2 Source: Barclays TIPS represented by the Barclays US Tips Index and UK linkers

represented by the Barclays UK Inflation-Linked Index.

This information discusses general market activity, industry or sector trends, or other

broad-based economic, market or political conditions and should not be construed as research or

investment advice Please see additional disclosures.

Source: Barclays, as of 10/31/09 US TIPS represented by the Barclays US Govt Inflation-Linked Bond All Maturities Index Nominal bonds represented by the Barclays US Govt Break-Even Inflation-Linked Bond All Maturities Index, which provides a simple framework for comparing returns on an inflation-linked bond market with a nominal bond market The Break-Even index includes nominal bonds that are maturity-matched with an inflation-linked bond index, which provides a much better comparison of relative performance than comparing a linker index with a conventional bond market index

0 5 10 15 20 25 30

35 GSCI S&P 500 US Nominals US TIPS

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Barclays US Aggregate 0.74

Barclays US High Yield 0.43 (2% constrained)

GSCI Commodities 0.34

TIPS: Less Volatility

TIPS have been less volatile than other asset classes over the long term but have demonstrated short-term volatility since 2008

Source: Goldman Sachs Asset Management.

Source: Bloomberg, 5-year correlation of Barclays U.S TIPS Index as of 10/31/09

Regardless of how inflation moves in the near term, history has shown that spikes in inflation can occur without warning, particularly after long periods of low inflation Thus, the best time

to hedge a portfolio against inflation can be before it starts rising Investors looking to employ inflation-linked strategies in their portfolios should understand how these securities react to changing market conditions over shorter periods Inflation-linked bonds have proved to be volatile over the near term, and positive performance may follow periods of low or negative inflation, and vice versa An active manager can help identify the most attractive opportunities within this unique market segment and help mitigate issues with liquidity and cost

Conclusion

Besides potential for short-term volatility, interest payments of

inflation-linked bonds will decline in a deflationary environment,

although investors in most countries will receive the full principal if

they hold the bonds to maturity For example, the US and France

guarantee a “deflation floor” in which they will repay the initial par

value at maturity, no matter what the inflation environment Below

are some of the other main risks of inflation-linked bonds:

mis-measures the actual increase in prices of goods and services

that the bond holder is trying to hedge, or that the index

computation will be altered in a way that is adverse to the

interests of the bond holders This can influence the breakeven

rate in periods of very volatile inflation

than comparable nominal bonds, which may raise real yields

rising interest rate environment When a central bank starts

raising rates, real yields are likely to rise and the prices of

inflation-linked bonds are likely to decline

What are some of the main risks of inflation-linked bonds?

This information discusses general market activity, industry or sector trends, or other

broad-based economic, market or political conditions and should not be construed as research or

Behind the industry jargon

Breakeven inflation

The difference between real and nominal bond yields, including

both the expected inflation rate and the inflation risk premium It is

a rough measure of the market’s inflation expectations

CPI

The Consumer Price Index (CPI) is a measure of the average change

over time in the prices paid by urban consumers for a market basket

of consumer goods and services

Deflation

A sustained, broad-based decline in the price of goods and services

Inflation risk premium

The additional yield that bond buyers demand to take on the risk of

inflation

Linkers

A general name for any bonds issued by governments whose

principal and interest are adjusted to reflect changes in inflation

Nominal yield

The yield of a conventional bond, which includes the real yield, the

expected inflation rate and an inflation risk premium

RPI

The Retail Prices Index (RPI) measures the level of retail prices in

the UK

Real return

The return on an investment that is adjusted to reflect changes in

inflation

This information discusses general market activity, industry or sector trends, or other

broad-based economic, market or political conditions and should not be construed as research or

investment advice Please see additional disclosures.

Following is a list of GSAM publications that can help you further explore and expand your understanding of fixed income investing

쐍 Derivatives

쐍 Mortgages, bank loans and structured credit

쐍 Corporate credit

쐍 Currencies

쐍 Commodities

Please contact your relationship management team

to obtain a copy of these materials.

Learn more

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