Over the past five years, investors have embraced the idea that incorporating inflation-indexed bonds into a portfolio, at the expense of nominal bonds, leads to the creation of a more efficient portfolio. This is because inflation-indexed bonds have the same expected return as nominal bonds, while having lower risks and lower correlations with other asset classes.

Now the big question investors in inflation-indexed bonds are asking is ‘global or domestic – which is better for my portfolio’. Here we aim to help investors answer this question.

In short, a currency-hedged investment in global inflation-indexed bonds will produce a higher expected return and a lower risk in a portfolio, compared to an investment in domestic inflation-indexed bonds, because:

• A portfolio of global inflation-indexed bonds has the same expected return as a portfolio of domestic inflation-indexed bonds if passively held and a higher expected return if actively managed. This is because the active manager has a wider opportunity set.

• A portfolio of global inflation-indexed bonds has a lower risk than a portfolio of domestic inflation-indexed bonds. This is because it is more diversified.

• A portfolio of global inflation-indexed bonds is less correlated with domestic assets, which typically constitute the largest portion of a portfolio, so it is a more effective diversifier for the total portfolio. That is because domestic assets are affected by domestic interest rates more than by global interest rates.

• The global inflation-indexed bond market is larger and more liquid, allowing for larger positions and reduced transactions costs.

• A portfolio of global inflation-indexed bonds maintains a high correlation to the domestic inflation rate. The reason for this requires a bit of explaining.

Why currency-hedged global inflation-indexed bonds maintain a high correlation with the domestic inflation rate


Table one  shows the correlation of domestic inflation-indexed bonds to local inflation versus a portfolio of global inflation-indexed bonds to local inflation. A global inflation-indexed bond portfolio, when currency hedged, is as correlated to inflation as the domestic portfolio, though neither portfolio is perfectly correlated to inflation.

There are three main reasons for this:

• Currency hedging tends to compensate for differences in local inflation rates.

• Diversification of real yields means lower real yield volatility, which is a primary cause of divergence between domestic inflation-indexed bond returns and domestic inflation.

• Inflation is a global phenomenon, particularly among major developed countries.

1. Currency hedging mitigates differences in inflation

The relationship among global inflation rates is important directionally, but levels of inflation – not just their correlation – must be addressed. Currency hedging tends to do exactly that. Its returns incorporate the spot currency return and the short-term interest rate differential. When hedging currency risk from one currency to another, spot currency risk is cancelled, and the residual return equals the difference in short-term interest rates of the two countries. Over the long term, this is highly correlated to differences in inflation rates and actually compensates for differences in inflation that may arise between the two countries, thereby adjusting the inflation characteristics of the bond. This effect can significantly change the profile of inflation-indexed bonds in foreign markets. As an example, consider Japan in the 1990s. Japan was going through deflation for much of the decade. One might think that had Japan issued inflation-indexed bonds during that period, the low level of inflation compensation would have been unattractive to US investors interested in hedging against the higher inflation rate of the US. Even though the inflation differential on its own would have severely under-compensated the US investor relative to US inflation levels, this would have been offset by the interest rate differential embedded in the currency hedge (see chart). As the inflation levels of the two nations diverged, their interest rates also diverged in such a way as to largely (though not completely) cancel out each other, thus the net level of inflation for which the US investor was compensated would have been closer to US inflation levels.

2. Diversification of real yields means lower real yield volatility

The return of inflation-indexed bonds is a function of both the inflation rate and changes in real yield. In the short-run, changes in real yields are the more important drivers. Changes in real yields have little to do with inflation rates, so they reduce the correlation of an inflation-indexed bond with inflation. When one holds a portfolio of global inflation-indexed bonds, the volatility of real yields is less because of the diversification effects. This allows the correlation to inflation to be higher than it would otherwise be.

3. Inflation is a global phenomenon

Inflation rates are highly correlated across developed countries, as shown in table two. This makes sense given that all major countries are reliant on the same underlying commodities, and there is significant integration of economic growth and monetary policy.

Even in Japan, where deflation has been the norm for the past five years, if you focus on the relationship of changes in inflation rates and not absolute levels, the correlation between Japanese and US inflation rates is 0.68 over the past 30 years.

Major developed economies rely on similar commodities, which is one of the reasons that their inflation rates are so highly correlated. For example, food and energy prices have a large impact on inflation in all of these markets. The absolute impact a rise in food and energy prices will have on the consumer price index (CPI) in the US and the HICP in Europe will differ but, all else being equal, if food or energy prices rise then inflation in all major developed countries will rise.

Energy prices are particularly interesting because they are not only global, but their impact can be substantially greater than their direct weight in the CPI for two reasons. Firstly, energy prices are implicit in the prices of many other goods in an economy (e.g., airfares or manufactured goods). Secondly, energy prices are much more volatile than other components of CPI. Table three shows that changes in energy prices have significant explanatory power in several inflation-indexed bond markets, underscoring how global inflation pressure affects inflation similarly in different countries.

Given the similarity in the makeup of CPI indices across countries, we expect inflation to be highly correlated across countries in the future, making global hedged inflation-indexed bonds a continued proxy for domestic inflation.

We do not want to suggest that there is a precise relationship between interest rate differentials and inflation differentials, since they do not always match. Over time, however, they tend to be correlated since central banks tend to set short-term interest rates with reference to inflation.

In summary, most investors are better off holding a diversified portfolio of global inflation-indexed bonds rather than a portfolio of domestic inflation-indexed bonds, when consideration is given to the effects on the total portfolio.

Ray Dalio is president and chief investment officer at Bridgewater Associates.