Emerging Market Inflation-Linked Bonds

Abstract

Investigating the value added by inflation-linked bonds in investment portfolios in emerging markets, the author found that the inclusion of inflation-linked bonds improved the risk–return characteristics of investment portfolios in many of the emerging markets. He also found that inflation-linked bond returns correlate more positively with realized inflation than do nominal bonds, even in the short run. Thus, investors should consider adding emerging market inflation-linked bonds to their investment portfolios.

I investigated the value added by inflation-linked bonds in an investment portfolio. Recently, several studies have questioned the value added by inflation-linked bonds on the basis of empirical analyses of developed markets only. The disadvantage of using those markets is that they have experienced low and stable inflation rates since the introduction of inflation-linked bonds. In times of low and stable inflation, the inflation protection embedded in inflation-linked bonds does not seem to be beneficial to investors. However, such empirical analyses do not imply that inflation-linked bonds are an unattractive asset class in general. Studying countries that have issued inflation-linked bonds in an environment of higher and more volatile inflation rates can provide useful insights for investors that worry about future inflation risk. Extending the cross section of countries with a set of nine emerging markets, I found that for many of these countries, the inclusion of inflation-linked bonds improves the risk–return characteristics of investment portfolios. This finding implies that investors in developed markets who take into account future scenarios with higher or more volatile inflation rates can also benefit from allocating to inflation-linked bonds. I also documented that inflation-linked bond returns correlate more with realized inflation than do those of nominal bonds, even in the short run. Thus, investors in nominal bonds and equities should also allocate a significant amount to inflation-linked bonds. Furthermore, my mean–variance spanning tests indicate that international investors who already invest in emerging market nominal bonds and equities can benefit from adding emerging market inflation-linked bonds to their investment portfolios.