Inflation-indexed bonds and change in yield

CFA Level III Economics
#1

I am bothered by question 15 of reading 15:

QUESTION: Other than changes in the rate of inflation, specify two factors that impact the yields available on inflation-indexed bonds.

First, to determine the perimeter of the question:

  • my understanding is that when we talk about inflation-indexed bonds, we always talk about treasury bonds. At least the curriculum only addresses this type.

  • the question mentions “other than changes in the rate of inflation”.

As a result, it’s the same as answering the question: “what influences the real risk-free interest rates”. Am I correct so far?

The book gives the following answer to the question:

Factor 1: Overall economic growth and its corresponding impact on real interest rates bear a direct impact on IIB yields. A growing economy places upward pressure on all bond yields. Though the impact may be muted due to the nature of the IIB structure, IIBs are not immune to interest rate risk.

Factor 2: Investor demand for bonds in general and for IIBs in particular has an inverse impact on IIB yields. As with non-IIBs, rising investor demand serves to drive interest rates lower and the lack of investor demand drives up the yields that issuers must pay in order to sell the bonds they need to issue.

My issue is that I see these two answers as being only one single factor. frown Real interest rates tend to increase in periods of growth due to the increase in demand indeed. It is even said clearly in the curriculum:

“News of stronger economic growth usually makes bond yields rise (prices fall) because it implies greater demand for capital and perhaps higher inflation too.” (4.6.2. Nominal default-free bonds)

I could have thought of changes in short-term interest rate as another factor influencing yield during economic growth but the curriculum says no:

“Changes in short-term rates have less predictable effects on bond yields. More often than not, a rise in short-term rates will lead to a rise in longer-term bond yields. However, a rise in rates will sometimes be expected to slow the economy, and bond yields could fall as a result.” (4.6.2. Nominal default-free bonds)

Thanks in advance for your help!

#2

Demand can increase for reasons other than overall economic growth.

For example, demographic changes can change demand for bonds. An aging population will generally invest more in bonds than in equities as time goes by.

#3

Hi Magician,

I think we are not talking about the same thing here though. We are talking about the other side of the balance: demand for capital (demand for bonds being the supply of capital).

#4

CFA curriculum on inflation indexed bonds states:

Yields fall if inflation accelerates because these securities are more attractive when inflation is volatile.

I didn’t get the logic behind this statement. Shouldn’t the coupon adjust to reflect higher inflation, thus keeping the yield about the same?

Could someone please shed some light on it?

#5

I’m trying to understand this as inflation rises / becomes volatile, more investors will try to buy it, thus driving the (real) yields down.

But in this case it’s simply a derivative of supply and demand factor, why would curriculum outline it into a separate factor affecting yield on these type of bonds…

#6

It’s best strength is unexpected inflation.

If expected inflation accelerates, the real yield will adjust downwards to keep the total yield the same.