Inflation is one of the main risks that investors in fixed income want to be paid to accept. All else being equal, as the prices of goods and services rise, the same fixed coupon payment buys less of them than it did previously. Rising inflation therefore erodes the real value of fixed nominal cash flows, while rising inflation expectations prompt central banks to tighten financial conditions, influencing the level of yields and the shape of yield curves in fixed income markets. All else being equal, passive bond investors’ return expectations deteriorate when inflation rises.

For active fixed-income investors, however, inflation – like any other risk – can also present opportunities. With the right toolkit and sufficient freedom of manoeuvre, investors can generate positive returns from rising and falling inflation expectations, and from realised inflation that is higher or lower than the market was expecting. The two key questions for investors are, do current risk premia over- or under-compensate for actual inflation risks, and how will inflation expectations change over the period in question?

Providing answers requires us to analyse the four risk premia that combine to produce the yield – not to be confused with the return over a given investment horizon – on a nominal government bond. These are:

• The real risk-free rate: the nominal yield adjusted for the current rate of inflation.
• The real term premium: the extra yield investors demand on longer-dated bonds to compensate them for unexpected changes in economic growth or monetary policy. This is not directly observable but can be modelled.
• The expected inflation rate among market participants.
• The inflation risk premium: the level of compensation that current nominal yields offer for unexpected inflation volatility.

The real yield of a nominal government bond – coupon income, expressed as a yield on the bond’s price, after adjusting for inflation – equals the sum of the real risk-free rate and the real term premium. The sum of the expected inflation rate and the inflation risk premium is usually known as the “break-even inflation rate”. This expresses current market expectations of the average inflation rate over the period in question.

Changing expectations of how these four risk premia will evolve determine the direction of travel for nominal government bond yields. And together these four components – expressed as the real yield plus the break-even inflation rate – combine to form the nominal yield on a government bond.

Having identified the current levels of these four risk premia and decided how we think they will change over a given period, we can turn this view into active positions, whether absolute or relative to a benchmark.

Each of these risk premia can be traded separately, using individual instruments or combinations of them. An active fixed-income manager can therefore generate returns by taking positions either on nominal government bond yields, or on one or several of their risk premia.

Managers can position for falling real government bond yields directly by buying inflation-linked bonds and can use derivatives to position for rising real yields. They can take positions on real term premia via curve trades, in which over- and underweight, or long and short, trades are placed on bonds with different maturities. Positions on the break-even inflation rate can either be relative – by replacing nominal with inflation-linked bonds or vice versa – or outright via inflation swaps. Finally, options on inflation (inflation caps and floors) can be used to hedge out the risk of an unexpected jump (or fall) in inflation. The option price is a measure for the inflation risk premium.

Looking at US long-term bond markets since the beginning of 2020, the graphic shows how the various risk premia have shifted repeatedly over that period. This has led to changes in the market’s view of the outlook for inflation that have required active managers to shift their positioning to generate positive returns.

Chart: 10y US government bond yields (real and nominal) and break-even inflation
See the table below for a closer look at what was driving the changes during each period – and to learn about positioning ideas for different fixed-income instruments


Source: Allianz Global Investors

Market movements and corresponding positioning options to generate alpha
Consult the chart above to see where each period fits into the longer-term comparison of yields and inflation

Information herein is based on sources we believe to be accurate and reliable as at the date it was made. We reserve the right to revise any information herein at any time without notice. No offer or solicitation to buy or sell securities and no investment advice or recommendation is made herein. In making investment decisions, investors should not rely solely on this publication but should seek independent professional advice. However, if you choose not to seek professional advice, you should consider the suitability of the product for yourself. Past performance of the fund manager(s) and the fund is not indicative of future performance. Prices of units in the Fund and the income from them, if any, may fall as well as rise and cannot be guaranteed. Distribution payments of the Fund, where applicable, may at the sole discretion of the Manager, be made out of either income and/or net capital gains or capital of the Fund. As a result, it may reduce the Fund’s net asset value. The dividend yields and payouts are not guaranteed and might change depending on the market conditions or at the Manager’s discretion. Investment involves risks including the possible loss of principal amount invested and risks associated with investment in emerging and less developed markets. The Fund may invest in financial derivative instruments and/or structured products and be subject to various risks (including counterparty, liquidity, credit and market risks etc.). Investing in fixed income instruments (if applicable) may expose investors to various risks, including but not limited to creditworthiness, interest rate, liquidity and restricted flexibility risks. Changes to the economic environment and market conditions may affect these risks, resulting in an adverse effect to the value of the investment. During periods of rising nominal interest rates, the values of fixed income instruments (including short positions with respect to fixed income instruments) are generally expected to decline. Conversely, during periods of declining interest rates, the values are generally expected to rise. Liquidity risk may possibly delay or prevent account withdrawals or redemptions. Past performance, or any prediction, projection or forecast, is not indicative of future performance. Investors should read the Prospectus obtainable from Allianz Global Investors Singapore Limited or any of its appointed distributors for further details including the risk factors, before investing. This publication has not been reviewed by the Monetary Authority of Singapore (MAS). MAS authorization/recognition is not a recommendation or endorsement. The issuer of this publication is Allianz Global Investors Singapore Limited (79 Robinson Road, #09-03, Singapore 068897, Company Registration No. 199907169Z).