Timeless Wisdom from Warren Buffett
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Breaking down the anatomy of inflation-protected bonds versus their nominal (non-inflation-protected) counterparts may be useful for investors weighing the tradeoffs of hedging inflation.
The first component (common to all bonds, inflation-protected or not) comes from the real yield. This is the yield before inflation expectations and depends on the current level of rates as well as the bond’s maturity.
Nominal bonds also have a component of return that includes compensation for expected inflation and a premium for bearing inflation risk. The combination of those components is often referred to as break-even inflation. Holders of nominal bonds will break even for the inflation contribution if actual inflation ends up equivalent to the break-even measure.
However, actual inflation sometimes meaningfully deviates from expectations. Inflation-protected securities hedge the risk of unexpected inflation by replacing the expected inflation and risk premium components with a payment for actual inflation. Whether this tradeoff is positive or negative depends on how actual inflation compares to break-even inflation. All else being equal, if actual inflation is greater than break-even inflation, the real return would be higher with the inflation-protected security. The opposite would be true if actual inflation ends up being less than break-even inflation
This article originally appeared in Above the Fray, a weekly newsletter for Dimensional clients.
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