Beware, inflation is bearish even for inflation-protected bonds

The point is that inflation is bearish for nominal bonds as much as inflation-protected bonds. Indeed, as nominal yields begin to rise, investors will find it compelling to sell expensive TIPS to buy nominal US Treasury bonds at higher rates.

However, how hot does inflation need to run to justify likers as inflation hedge? 

TIPS: buy-to-hold or prepare for a capital loss

Taking the recent University of Michigan Survey as a reference, we'll assume an average annual inflation rate of 3% for the next five years.

Currently, five-year TIPS (US91282CCA71) pay a yield of -1.8%. If you were to buy the bonds today and hold them till maturity, your annual total return would be 1.25%, roughly 6% for the total holding period.

The problem arises if one needs to sell the bond before maturity. Let’s assume 5-year real yields rise to 0%. If you need to sell the bonds in one year, your total return will be -4.6%.

Therefore, if you are looking for inflation protection, TIPS may still work well in a diversified portfolio. Still, it may be necessary to hold them till maturity not to incur losses in a rising interest rate environment. For that purpose, it may be more convenient to hold TIPS outright rather than buying them through funds.

Don’t touch inflation-linked gilts

When looking for inflation protection in the UK, the situation becomes depressing. Investors buying into inflation-linked gilts will record a loss even if rates remain at current record low levels.

Five-year inflation-linked gilts (GB00BYY5F144) offer a yield of -3.2%. If you were to hold them until maturity and annual inflation averages around 3% during the next five years, you would still run into a slight loss of -0.60%.

Nevertheless, the consensus is for the Retail Price Index (RPI), which is used as a reference to pay out inflation-linked Gilts' coupons, normalize below 3% already by 2023. If that were the case, the loss incurred by investors holding five-year index-linked gilts becomes larger. To make the case of buying into 5-year inflation-linked compelling, we would need inflation to be around 3.2% yearly over the next five years.

Therefore, although buying into index-linked gilts looks like a sensible hedge, it doesn’t make sense to hold them at current levels. 

The case for EUR denominated inflation-linked bonds

Moving on to continental Europe, it's possible to find several inflation hedges depending on the country we are looking at. This analysis will look at inflation-linked German and Italian bonds, which are respectively the most and least expensive European inflation hedges. They both protect against Eurozone inflation and are linked to the Eurostat Eurozone HICP Ex Tobacco Index.

Although real yields are deeply negative, the yearly average inflation rate needed to break even is much lower than UK peers. In the case of 5- and 10-year index-linked German government bonds, you'll need inflation to average 2.20% and 2.60% per year, respectively.

Much cheaper, Italian inflation-linkers offer a bigger buffer against inflation. If held till maturity, 5- and 10-years BTPS will break even with a yearly average inflation rate of 1.55% and 0,8%, respectively.