S&P report says yields on inflation bonds track national credit ratings

Standard & Poor’s, which assigns credit ratings to national governments, among the many things it does, issued a report yesterday that says there’s a good correlation between a country’s credit rating and yields on its inflation-linked bonds.

The report says 22 nations issue inflation-linked bonds like US Treasury Inflation Protected Securities (TIPS). A country’s credit rating explains about 60% of the variability in the yields for inflation-protected securities, the S&P report says. Moreover, S&P says it expects this correlation to become more robust as inflation-linked bonds become a recognized asset class and liquidity improves.

What this means is that when the base rate on Series I Savings Bonds and TIPS goes up, the faith of investors in the credit worthiness of the US Treasury is declining.

Here’s S&P’s complete press release on the new report:

Inflation-Linked Bond Yields Correlate Well With Local Currency Sovereign Ratings, Says Report

LONDON Aug. 2, 2006-Real returns on government inflation-linked bonds are a good proxy for Standard & Poor’s Ratings Services local currency sovereign credit ratings, Standard & Poor’s 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 that Standard & Poor’s rates.

“Across a sample of 22 governments, differences in credit ratings explain 60% of the variation in yields, with higher ratings corresponding to lower yields,” said Standard & Poor’s credit analyst Tim Reid. “This relationship broadly matches that between foreign currency sovereign credit ratings and the spreads on U.S. dollar-denominated nominal bonds.”

Nevertheless, the study uncovered a number of outliers. Inflation-linked bonds issued by Italy, Greece, and Japan have relatively low ratings-adjusted real yields, while those of Brazil, Iceland, and Peru have relatively high real yields. The sources of these deviations lie, respectively, in the ability of Italy and Greece to issue bonds in euros, the current idiosyncratic level of real returns in Japan, and the illiquidity, monetary policy stance, and relative lack of international investment in the inflation-linked bond markets of Brazil, Iceland, and Peru.

There are also a number of more general reasons that may lead to deviations for the correlation 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. In other words, the inflation risk premium varies across countries and across time.

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 asset class globally with 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. Reid.

The report is available to subscribers of RatingsDirect, the real-time Web-based source for Standard & Poor’s credit ratings, research, and risk analysis, at www.ratingsdirect.com. If you are not a RatingsDirect subscriber, you may purchase a copy of the report by calling (1) 212-438-9823 or sending an e-mail to [email protected].