Inflation breakeven rate

on Oct 11, 2012 in Economy, Home | 1,401 comments

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Inflation breakeven rate refers to the difference between the nominal yield on a traditional bond and the real yield on an inflation-linked bond with the same maturity. It has been used as a tool to obtain the expected inflation.

Nominal rate ≈ real rate + inflation expectation

In fact, the nominal rate of return incorporates the real rate, expected inflation, inflation risk premium and a liquidity risk premium.

Nevertheless, assuming the inflation and liquidity risk premium to be fairly stable over a short period of time, the changes in the breakeven inflation rate capture the changes in inflation expectations.

Your fixed-income investments may not consequently provide the real return investors seek during periods of high inflation. It’s important to know whether your traditional fixed-income investment breaks-even with inflation. If inflation averages more than the break-even, the inflation-linked investment will outperform the fixed-rate. Inversely, if inflation averages below the break-even, the fixed-rate will outperform the inflation-linked.

It is possible to benefit from the rise in inflation while being hedged against rising interest rates by buying inflation-linked bonds and selling traditional sovereign bonds with similar maturity.

Ultimately, for inflation-linked bonds to offer a potentially safe way to preserve real wealth they should not have any credit exposure. However, Italian inflation-linked bonds as well as their nominal counterparts trade at a discount to compensate for the higher volatility and credit risks.

Most investors realize that they should be cautious when using the break-even rate, because many other factors enter into bond prices besides inflation expectations, including inflation risk premium and a liquidity risk premium and also credit risks.