Link between inflation bonds and national credit ratings declines

Monday, November 19th, 2007
Categorized as: Series I US Savings BondsTIPSUS Credit Rating

According to a report issued by Standard & Poor’s a year ago, which I reported on here, a country’s credit rating explained about 60% of the variability in the yields for inflation-protected securities. In a new report, issued today, that’s down to 52%.

In addition, the new report raises concerns, currently centered on Argentina, that the CPI measures a government uses may underestimate inflation, which would cause the base rate on inflation linked bonds to be higher.

Here’s the entire press release from Standard & Poor’s on their new report:

LONDON Nov. 19, 2007–Despite concerns about possible manipulation of inflation indices in certain countries, real yields on government inflation-linked bonds continue to track sovereign local currency credit ratings, Standard & Poor’s Ratings Services said in a report published today.

The report, titled “Inflation-Linked Bonds And Sovereign Credit Risk,” discusses the results of regression analysis on the yields of local-currency-inflation-linked bonds issued by 22 sovereigns rated by Standard & Poor’s.

“Across a sample of governments, differences in credit ratings explain 52% of the variation in yields, with higher ratings corresponding to lower yields,” said David Beers, Managing Director and Global Head of Sovereign & International Finance Ratings for Standard & Poor’s. “This relationship mirrors that found between foreign currency sovereign credit ratings and the spreads on U.S. dollar-denominated nominal sovereign bonds.”

Nevertheless, the study uncovered a number of outliers. Inflation-linked bonds issued by Italy, Greece, Peru, and Japan have relatively low ratings-adjusted real yields, while those of Turkey, Iceland, and New Zealand have relatively high real yields. The sources of these deviations lie, for example, in the ability of Italy and Greece to issue bonds in euros; the home bias of domestic investors in Japan; and the illiquidity, monetary policy stance, and relative lack of international investment in the inflation-linked bond markets of Turkey, Iceland, and New Zealand.

The report also suggested another problematic technical factor, concerning the creditability of the index to which the bond is linked and incentives for official agencies to manipulate the reference index. For example, Argentina’s inflation-linked bonds are controversial because many market participants believe that the country’s official CPI understates the actual level of inflation. As a result, the real rate of interest on Argentina’s inflation-linked bonds reflects the divergence between measured and actual inflation, as well as the government’s credit risk.

“If official manipulation of the indices used to adjust nominal interest and principal payments of inflation-linked bonds became widespread, it would inevitably reduce the attractiveness of these securities to investors,” noted Mr. Beers. “Even when perceptions of manipulation wane, the damage to government credibility can be lasting.” This is evident in Argentina, where real yields on inflation-linked bonds trading in the secondary market have risen in response to market concerns about the reliability of CPI.

There are other reasons for deviations between inflation-linked bond yields and local currency credit ratings. For example, if inflation is more volatile in some countries than in others, the security acquired through the purchase of inflation-linked bonds is worth more, leading to price and yield differences.

Looking ahead, however, we expect that the relationship between real returns on inflation-linked sovereign bonds and Standard & Poor’s credit ratings will become even more robust, as these instruments become a distinct global asset class with greater cross-border investment and increased levels of liquidity.

“The issuance of inflation-linked bonds is also important from a creditworthiness perspective because, where there is a demand for such paper, the government gains an additional cost-effective debt instrument and the central bank gains useful pricing signals for inflation expectations,” concluded Mr. Beers.

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