Inflation is one of the key drivers of investment performance for all asset classes. From 1983 to 2000, a period marked by falling inflation, declining raw material prices allowed corporate margins to expand. Concurrently, decreasing interest rates saw a reciprocal increase in price-to-earnings multiples being attached to these increasing earnings. The combined effect led to turbo-charged equity returns. The opposite happens during bouts of rising inflation. The 17-year inflationary period from 1966 to 1983 was one of the worst investment climates in modern history for equities, bonds, and cash.
Last year, the Australian government started offering exchange-traded bonds that can be bought and sold on the ASX like ordinary shares. They offer traditional Treasury Bonds (TB) and Treasury Indexed Bonds (TIB), the latter being the subject at hand.
TIBs are bonds that promise to protect and grow an investor’s purchasing power. Canberra delivers on this promise by adjusting the principal of the bond in-line with changes in the consumer price index (CPI). That is, it repays the bondholder’s principal in an amount that exactly maintains the purchasing power of the original investment.
Furthermore, they also pay interest at a set rate on this CPI-indexed amount, so the purchasing power of the quarterly interest payments are also preserved. These securities are a potent weapon against the fear of inflation.
Tactically, investors are presented with an opportunity to speculate on changes in inflation and real interest rates. Strategically, investors with long-term objectives have at their disposal an asset with a fixed real yield, low correlation to traditional financial assets and muted volatility. Their unique characteristics justify considering them as a fundamental asset class, distinct from equities, real estate, traditional bonds and cash.
They have relatively high correlations with one another and modest or negative correlation with other asset classes. As a whole they form a large, investable, and easily benchmarked universe. So now that retail investors can easily observe nominal and inflation-protected government bonds trading on the ASX, what do their prices say about future rates of inflation?
Break-Even Inflation Rate
The break-even inflation rate is the rate that the holder of a TIB breaks even with the holder of a nominal TB. To compare the two, we need to calculate the TIB’s nominal yield. It can be approximated as
TIB realised nominal yield = (1 + real yield) x (1 + inflation rate) -1
If we have a conventional bond of the same maturity, the nominal yield of the TIB can be set equal to the yield of the conventional bond. We can then solve for the break-even inflation rate:
Break-even inflation rate = (1 + TB yield) / (1 + TIB real yield) - 1
We took the prices of TB and TIBs maturing on or near 2015, 2020, 2025, 2030 and 2035 and calculated the break-even inflation rate to see where Mr. Market thinks inflation is headed. So, where does Mr. Market see inflation rates in 5, 10, 20 years time? 
Basically unchanged from where we are today.
My outlook is less sanguine, but I’m wise enough to know I don’t know where inflation is headed. A better question to ask yourself is what mix of assets do I need to own (and in what proportion), to navigate a range of inflationary outcomes and preserve my purchasing power?
