What are indexed bonds?

In recent months, we’ve seen the prices of consumer goods and services ease, both in Europe and the United States, after reaching their highest point in the last 40 years. However, this decrease in inflation is not coming as quickly as was expected initially, and therefore we must protect our investments with products that adapt to this type of context, such as indexed bonds. The return on these bonds is linked to an economic magnitude, such as the cumulative inflation of a specific economy from the time the bond is issued.

“Normally, the principal is protected and at least the full 100% must be recovered, even if there’s cumulative deflation. In other words, the real interest rate you invest at when you purchase these bonds is protected from future inflation, because if cumulative inflation increases from their issue, the coupons you are paid and the principal at maturity also increase,” explains Daniel Gómez, fixed income manager at MAPFRE AM.

As explained by the Spanish Treasury on its website, "if the reference index corresponding to the maturity date is lower than the base index, the return will be equal to the nominal amount".

Gómez adds that this type of bond is suitable for any type of investor whose objective is to protect themselves from inflation, although it is usually a market more favorable to institutional investors “due to its relative complexity.”

For example, a Germany two-year bond indexed to European inflation offers a real yield (protected from inflation) of 0.92%, while a normal bond (without protection) from the same issuer, with the same maturity (interpolated), would yield 2.62%. In other words, the difference between 2.62% and 0.92% is 1.70%. “If we think that inflation over two years is going to be above that level, we should buy the inflation-linked bonds instead of the nominal (normal) ones,” he says.

The forecasts by MAPFRE Economics, MAPFRE’s research arm, estimate inflation in the Eurozone will be around 2.5% this year in its baseline scenario, the most likely scenario, although this rate could increase up to 2.9% if current geopolitical conflicts worsen, among other risks.

Therefore, indexed bonds may remain relevant. However, the increase in prices in other economic areas is higher: in the United States, it will be around 2.7%, while in the United Kingdom it will increase to 3.2%, and in emerging markets as a whole, it could hit 6.2%.

“If we compare the current yield of a two-year nominal bond with that of an inflation-indexed bond we see that the market is predicting price increases below 2% in Europe, when we're currently at 3.4%, and there are ongoing geopolitical conflicts such as Ukraine and the Red Sea that could once again generate bottlenecks in the supply chain and increase the price of transportation and raw materials,” Gómez insists.

Additionally, in periods when interest rates are increasing, these bonds “generally perform better than nominal bonds.” However, there are also some disadvantages: their market liquidity is lower and, logically, they perform worse than nominal bonds in periods when inflation is expected to decrease.

Expectations for rate cuts on hold

Markets are expecting between six and seven interest rate cuts, even though the data don’t support these decisions in the case of the United States: the country's economy remains strong, and inflation is still too high for these cuts to take place. In fact, inflation in the country was at 3.1% in January, three tenths below December’s figure, but higher than the 2.9% expected by analysts.

“In theory, this piece of data should delay expectations for rate cuts,” explains Alberto Matellán, lead economist at MAPFRE Inversión. “It seems as though inflation isn't decreasing as much as was expected, and it will remain at current levels, which is higher than most analysts predicted.”