Jun 29, 2023·edited Jun 29, 2023Liked by Paper Alfa

Good work as always! I would though add that it is a bit misleading to say that "In other words, investors are better off buying the linker rather than the nominal bond if realised inflation turns out to be higher than what was priced in the linker market at the time of purchase, and vice versa." From a trading perspective, what matters is just this difference between nominal and breakeven rates, so when you buy a linker you are essentially placing a bet on (1) the FED/ECB's reaction function and (2) how sensitive the economy is to rates (how far the OIS curve goes up or down versus the inflation curve vs what is currently priced in). This is more obvious in EUR context as there the real rate is simply a residual given how liquid inflation swaps are.

thank you for your kind words. the beta of linkers to nominals is somewhere in the region of 0.6 - 0.8 in normal times and increased closer to 1 last year. Not sure which part is misleading which I disagree. The essence of holding a nominal vs real bond until maturity is precisely the consideration where realised inflation will be higher or lower than currently priced. Monetary policy reaction function and rate sensitivity is impacting nominals and reals to the same degree.

Suppose you buy a 5y linker with the expected 5y inflation at 2.3% - if after 5 years the realised inflation is at 2.5% will you have made money? According to what you wrote the answer would have to be yes - but it is not necessarily the case! Why? Because your p&l would also depend on how 5y nominal rates performed. If 5y nominal rates underperform on average by more than 20bps (so 2.5% - 2.3%) the next five years you will have lost money! This is obvious from the fact that being long an inflation linked bond you have two distinct deltas: you are IRS receiver and Inflation swap payer (this is true in the US context as well, albeit in a roundabout way given that us infl swaps are not that liquid), and I ignore here the credit spread.

yes, that's correct. I thought that I made it clear that its a relative evaluation not an absolute one as you correctly point out. If you trading the breakeven you are buying tips and selling nominal duration against it. Or in Mandalorian speak, this is the way! ;)

Amen to that!

Great overview. Not my cuppa, but ideal for a friend who likes TIPS.

you got weird friends!

edited Jun 29, 2023Good work as always! I would though add that it is a bit misleading to say that "In other words, investors are better off buying the linker rather than the nominal bond if realised inflation turns out to be higher than what was priced in the linker market at the time of purchase, and vice versa." From a trading perspective, what matters is just this difference between nominal and breakeven rates, so when you buy a linker you are essentially placing a bet on (1) the FED/ECB's reaction function and (2) how sensitive the economy is to rates (how far the OIS curve goes up or down versus the inflation curve vs what is currently priced in). This is more obvious in EUR context as there the real rate is simply a residual given how liquid inflation swaps are.

thank you for your kind words. the beta of linkers to nominals is somewhere in the region of 0.6 - 0.8 in normal times and increased closer to 1 last year. Not sure which part is misleading which I disagree. The essence of holding a nominal vs real bond until maturity is precisely the consideration where realised inflation will be higher or lower than currently priced. Monetary policy reaction function and rate sensitivity is impacting nominals and reals to the same degree.

Suppose you buy a 5y linker with the expected 5y inflation at 2.3% - if after 5 years the realised inflation is at 2.5% will you have made money? According to what you wrote the answer would have to be yes - but it is not necessarily the case! Why? Because your p&l would also depend on how 5y nominal rates performed. If 5y nominal rates underperform on average by more than 20bps (so 2.5% - 2.3%) the next five years you will have lost money! This is obvious from the fact that being long an inflation linked bond you have two distinct deltas: you are IRS receiver and Inflation swap payer (this is true in the US context as well, albeit in a roundabout way given that us infl swaps are not that liquid), and I ignore here the credit spread.

yes, that's correct. I thought that I made it clear that its a relative evaluation not an absolute one as you correctly point out. If you trading the breakeven you are buying tips and selling nominal duration against it. Or in Mandalorian speak, this is the way! ;)