Abstract
Recent empirical research has questioned the added value of inflation-linked bonds (ILBs) in a diversified portfolio, especially in the euro area. This paper relates this finding to the choice of price index. Euro area issuers of ILBs can choose between linking to a euro area or a national price index. We theoretically show that bonds linked to euro area inflation are less useful for diversification purposes than nationally ILBs. We also show that bonds linked to national price indices are imperfect hedges for national inflation. The latter finding is counterintuitive and arises because of monetary union. Our findings suggest that euro area governments may better service international investors with ILBs linked to their national price indices.
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Notes
1. Shen (Citation1995) and Price (Citation1997) review the pros and cons of ILBs. Deacon, Derry, and Mirfendereski (Citation2004) discuss the empirical evidence. Campbell, Shiller, and Viceira (Citation2009) explore the history of ILBs in the US and UK markets. An earlier extended version of this paper is available as working paper (Arnold Citation2006).
2. Swinkels (Citation2012), however, shows that this conclusion does not hold for emerging markets ILBs.
3. We acknowledge that since 2009 the eurocrisis has severely tested these assumptions. As indicated earlier, this paper focuses on euro area differentials in (expected) inflation on ILB pricing and refrains from an analysis of credit risk or convertibility risk.
4. The standard deviations are calculated from monthly ECB data.