Real Rates and Inflation-Linked Bonds: The EM Secret Weapon

Previous: EM Rates - Inflation and Central Banks

Chapter 7 is titled “Real Rates: Simply Superior.” That’s not a suggestion. It’s a thesis statement. The authors make a strong case that inflation-linked bonds in emerging markets deserve way more attention than they get. And honestly? The data backs them up.

What Are Linkers and Why Should You Care

Inflation-linked bonds (linkers) are bonds where the principal adjusts with inflation. So instead of locking in a nominal yield and hoping inflation doesn’t eat your returns, you lock in a real yield and let the bond’s principal grow with the price level. Your coupon payments grow too, since they’re calculated on the inflation-adjusted principal.

In developed markets, you’ve got TIPS in the US and index-linked gilts in the UK. In emerging markets, the linker universe is actually pretty big. The FTSE EM Inflation-Linked Security Index (EMILSI) had about $460 billion in market cap as of end-2018. That’s roughly one-fifth of the nominal EM bond market.

The biggest linker markets in EM are Brazil (52% of the index), Mexico (16%), Chile (9%), Turkey (8%), South Africa (8%), and Colombia (7%). Israel also has a well-developed linker market. Each of these countries has its own reasons for building out this market, but the common thread is a history of inflation that made investors nervous about committing to long-duration nominal bonds.

Brazil is the poster child here. The country’s linker market ($238 billion) is actually bigger than its nominal bond market ($109 billion). That’s wild. It’s a direct legacy of Brazil’s history of violent inflation episodes. Investors needed real-rate bonds to feel comfortable going long duration. The average life of linkers in Brazil is about 14 years, compared to just 4.8 years for nominals. If you want duration in Brazil, linkers are basically your only option.

Chile is interesting too. Its linker market cap is bigger than its nominal market, a leftover from when the whole monetary system was set up around an inflation-linked currency. In Chile, linkers are sometimes more liquid than nominal bonds for certain maturities.

Linkers Sleep Better at Night

The chapter title says “Simply Superior,” and here’s the core argument.

On a duration-adjusted basis, nominal bonds usually outperform linkers over time. That’s just math. Nominals are more volatile, so they do better in bull markets. And the period the authors studied (roughly 2009-2018) was mostly a bull market for EM rates.

But here’s where it gets interesting. The only times linkers outperform are during sharp sell-offs. When things get ugly, nominals drop hard. Linkers drop too, but way less. During the 2018 sell-off, linker returns were basically flat while nominals got crushed.

Why does this happen? When EM currencies weaken (which they tend to do during sell-offs), inflation expectations go up. That’s because a weaker currency means imports cost more, which feeds into higher CPI. Linkers benefit from this dynamic. So linkers act as a natural hedge for exactly the scenario that keeps EM investors up at night.

This lower volatility translates into better risk-adjusted returns. The authors found that over their study period, the information ratio for linkers was 1.62, compared to 1.47 for nominals. Same direction of returns, but smoother ride.

Their advice: if you can use leverage, consider leveraging up linkers rather than buying nominal bonds. You get similar return potential with less downside pain.

When to Own Linkers vs. Nominals

This is the tactical part, and it’s genuinely useful. The authors lay out several rules of thumb for switching between linkers and nominals.

Rule 1: Easing cycles favor nominals

During easing cycles (from the last hike to just before the last cut), nominal bonds significantly outperform linkers. The logic is straightforward. Easing cycles only happen when inflation expectations aren’t rising sharply. And nominals, being more volatile, capture more upside in bull markets. The data confirms this. After the last hike, nominals show strong and consistent outperformance over linkers.

Rule 2: Hiking cycles slightly favor linkers

After the last cut (start of a hiking cycle), nominals stop outperforming as clearly. For the first 120 days, the relative performance goes sideways. The authors expected linkers to outperform more during hiking cycles, but the structural disinflation trend across EM during 2009-2018 worked against that hypothesis.

Still, the takeaway is clear: switch to linkers around the last cut, but don’t overstay. After about 120 days, nominals start to do better again even in hiking cycles.

Rule 3: UST rallies favor nominals

When US Treasuries rally, EM nominals outperform linkers. This correlation is strong and consistent. UST rallies often coincide with “grab for yield” episodes or Fed easing, both of which support nominal rates globally. Since UST were largely in a bull market during the 2010s, this tailwind kept nominals ahead of linkers for most of the decade.

Rule 4: Commodity rallies favor linkers

Linkers reference headline inflation, not core inflation. So when oil and food prices rise, linkers benefit directly. The authors show a strong fit between commodity performance and linker outperformance, with a few exceptions.

Rule 5: EMFX weakness favors linkers

This might be the most important one. When EM currencies weaken, breakevens widen because a weaker currency means higher import prices and eventually higher inflation. The authors argue that FX performance is actually a more important driver of linker outperformance than commodities, because FX impacts a larger share of the CPI basket.

The best environment for linkers: commodity prices rising while the local currency doesn’t appreciate. Or EMFX weakening without commodities selling off too much.

Valuing Breakevens: What’s Fair?

The authors’ approach to valuing linkers starts with a view on nominal bonds (based on central bank action and the global rates environment) and then layers on a view about breakeven inflation.

Long-term breakevens tend to sit slightly above the upper end of the central bank’s inflation target band. Markets generally give central banks the benefit of the doubt on keeping inflation near target, but they demand a small premium for that trust.

Looking at Brazil, Chile, Colombia, and Mexico from 2013-2018, some patterns emerge:

Brazil had the highest inflation (median 6.3%) and missed its target the most (average miss of 1.7%). Breakevens traded below the inflation target only 5% of the time.

Chile had the lowest inflation (median 2.85%) but surprisingly high volatility relative to its level. Breakevens actually traded below target 65% of the time.

Mexico had the most stable inflation (lowest standard deviation at 0.99%), with breakevens below target only 8% of the time.

Colombia sat in the middle on everything.

The key finding: current inflation is a better predictor of 5-year breakevens than the 5-year average of past inflation. The median gap between breakevens and current inflation is small: slightly negative in Brazil and Mexico, slightly positive in Chile and Colombia. Markets put a lot of weight on whatever inflation is doing right now, even when pricing bonds that mature years from now.

This gives you a practical trading rule. When 5-year breakevens undershoot current inflation by 3 to 3.5%, that’s historically as extreme as it gets. Time to buy inflation. When breakevens overshoot current inflation by 1.5 to 2.5%, that’s the other extreme. Time to sell.

Another useful signal: when breakevens trade below the midpoint of the inflation target, that’s historically been a good entry point for going long inflation in Brazil, Colombia, and Mexico. Those episodes are rare and fleeting.

The Brazil Case Study

The authors spend extra time on Brazil, which makes sense given it’s half the linker index.

In Brazil, breakevens typically trade below current inflation during surges above 6% (the upper end of the target range). The market fades what it thinks could be temporary spikes. But breakevens follow realized inflation higher, sometimes with a lag.

On the downside, breakevens are sticky. When Brazil’s inflation briefly fell below the target of 4.5%, the 5-year breakeven refused to go below it. That makes the inflation target a pretty reliable floor for breakevens.

There’s also a neat signal using inflation expectations surveys. When 4-year breakevens fall below 1-year survey expectations, that’s a buy signal for inflation. It means the market is pricing in too little inflation risk relative to what economists expect. These episodes are rare but high-conviction.

The best trades happen when valuation and momentum line up at the same time. Depressed breakevens coinciding with the end of an easing cycle? Or stretched breakevens meeting the end of a hiking cycle? Those are the moments to go all in.

Is Low Inflation Structural?

The authors address the elephant in the room: what if EM inflation is just permanently lower now?

They’re skeptical. Yes, EM inflation fell sharply after the Great Recession. But within the post-2010 range, they don’t see an obvious ongoing downtrend for either EM or developed markets.

They point out that developed market central banks were actively trying to generate inflation through monetary policy, fiscal policy, and (maybe accidentally) trade policy. The authors figured those efforts would eventually succeed, probably right when everyone had given up expecting inflation to return.

For EM specifically, they acknowledge a slow structural drift lower as countries get wealthier and consume more services and fewer commodities. And some countries like Brazil were actively lowering their inflation targets. But EM currencies remain vulnerable to sudden weakness, which can spike inflation quickly. So the structural trend lower will stay slow compared to the cyclical swings around it.

The practical implication: the cyclical rules of thumb still work even if there’s a structural trend. But if you believe inflation is genuinely disappearing, you’d want to bias toward nominals and adjust downward what counts as “too little” inflation risk premium.

The Bottom Line

Linkers are an underappreciated tool in EM fixed income. Here’s the summary:

For long-term investors: Real rates offer better risk-adjusted returns than nominals. Lower volatility, better information ratios, and natural protection during EM sell-offs. If you can lever up, linkers with leverage beat nominals on a risk-adjusted basis.

For tactical traders: Own nominals during easing cycles and UST rallies. Switch to linkers during hiking cycles, commodity rallies, and EMFX weakness. Don’t overthink it. These simple rules have worked well historically.

For valuation: Use current inflation as your anchor for breakevens. Buy inflation when breakevens undershoot current inflation by 3%+. Sell when they overshoot by 2%+. And treat the inflation target midpoint as a floor.

The biggest insight: The best trades combine valuation and momentum. When breakevens are cheap AND the cycle is turning in your favor, that’s when you size up.

The chapter title says it all. Real rates: simply superior.

Book Details:

• Title: Trading Fixed Income and FX in Emerging Markets
• Authors: Dirk Willer, Ram Bala Chandran, Kenneth Lam
• Publisher: Wiley
• Year: 2020
• ISBN: 978-1-119-59905-0

Previous: EM Rates - Inflation and Central Banks | Next: EM Rates Event Guide