A conventional bond’s value is eroded by inflation, a fact which introduces a meaningful risk to long-term bonds. When inflation is expected to remain stable, investors often try to match the duration of their bond investments to the duration of their liabilities. So, long-term investors like pension funds or individuals saving for their own retirement or to preserve intergenerational wealth would provide some demand for long-term bonds. However, when inflation is unpredictable, these investors no longer-trust long-term bonds and can even have their financial objectives imperiled by the lack of suitable investment options for their circumstances.
Two relatively early adopters of inflation-linked bonds, Israel and the United Kingdom, introduced these new securities because of the consequences of inflation. One consequence was that pension funds lacked a long-term investment asset they could trust. The other was that the government increasingly lost access to attractive long-term credit. In both countries, adoption of inflation-linked bonds was high and remained so.
Inflation-Linked Bonds
Unanticipated changes in the rate of inflation, more than the level of inflation itself, are a risk to long-term bonds. If inflation were merely high but stable, then nominal yields on bonds would be similarly high to offset that inflation and nominal bonds would retain their real (after-inflation) value. If inflation is not only high but is rising, then nominal bonds will lose value. Still, the initial price and yield of the bond would compensate investors for this but only if that inflation were correctly anticipated. However, if the inflation was unanticipated and therefore not priced into the bond upon its issuance, then the investor turns out to have not made a good investment at all.
In the mid-20th century, many parts of the world saw high, increasing, and volatile rates of inflation. So, real returns on ‘safe’ bond investments were often disappointing or even negative, particularly when inflation rose in many Western countries in the 1970s. It is not surprising that interest in inflation-linked bonds rose in the mid-to-late 20th century.
Interest was particularly strong in relation to longer term securities. Investors in longer-term bonds are hurt most by the eroding power of inflation because they lock in an investment’s fixed nominal return, which proves to be insufficient in-hindsight, for longer periods of time. Amidst inflation, people may seek to index various contracts to inflation; a cost-of-living adjustment incorporated into either an employment contract or a pension are just two examples. Transactions that constitute long-term lending are also sensible candidates for becoming inflation-linked.
Still, outside of a small handful of cases, inflation-indexed government bonds were rare before the late-20th century. Even in some countries that held out on adopting them, they often had been considered at various points earlier in the century. Nonetheless, there was varied opposition. The opponents of inflation-linked bonds thought they would aggravate inflation. Their issuance would be seen as an admission by governments that inflation would remain high and might lead to indexing of other contracts to inflation which could accelerate price increases elsewhere. Some also thought the inflation-linked bonds would increase nominal borrowing costs or simply believed that nominal bonds were more favorable to the government and that inflation-linked debt issuances should therefore only be used as a last resort.
Introduction in Israel
One of the first countries to embrace inflation-linked bonds was Israel, which was dealing with high inflation in the early 1950s. This followed the 1948 Arab–Israeli War and large immigration to Israel. The end of rationing and price controls that had lasted through the wars allowed inflation to accelerate. Israeli inflation rose to over 60% in 1952, fell to a still-significant approximately 20% in 1953, and below 10% thereafter. In the next 16 years, inflation was averaging just 4.6% per year.
However, capital markets in this newly independent country had begun to develop during this period of high inflation and reflected those circumstances. Thus, the Israeli government could only borrow in its local currency with short-term debt. Investors were not keen to maker longer term loans in Israeli pounds that could be devalued. Meanwhile, some private entities were borrowing under inflation-linked loans because people had already expected the wartime controls to end and inflation to pick up.
Returns on these private debts were usually linked to the price of specific assets or products related to the business of the borrower. As just some examples, the Israel Land Development Company issued bonds convertible into common stock or land, the Nesher Cement Company issued bonds linked to the price of cement, and Mehadrin Orange Groves bonds were linked to citrus prices. Government loans made to private firms to develop the economy also became inflation-linked.
However, it was not so much the example of these private bonds that brought about the first inflation-linked Israeli government bonds. Rather, the investment challenges of pension funds prompted the introduction of inflation-protected investments in Israel. At the time, defined benefit pension payments were indexed to inflation, either by being linked to a price index directly or to the wages of workers of similar occupation to the work the pensioner held before they retired. However, the assets pension funds invested in did not offer sufficient protection against inflation. So, the liabilities, but not the assets, of pension funds grew with inflation.
The solution to the solvency problems facing pension funds after some time of this erosion was the creation of non-tradable inflation-linked bonds. These were inflation-linked bonds with subsidized coupons used to rescue underfunded pension plans. Some were issued in the mid-1950s exclusively to pension funds or life insurance companies and given their targeted purpose, they were not transferable to other types of investors.
Tradable inflation-linked bonds were eventually introduced. These had between 3- and 30-year terms and both the principal and interest payments were inflation-linked. When inflation picked up in the 1970s, public interest in inflation-indexed bonds increased. Then, an inflationary crisis struck Israel in the early 1980s and inflation rose to around 400% in 1984. The crisis was aggravated by, yet encouraged still further, indexation of salaries, rents, and other contractual obligations to inflation. In financial markets, nominal (non-inflation-adjusted) local-currency bonds became disfavored.
By 1997, 37% of Israeli government debt was in the form of non-tradable inflation-linked bonds alone and, including the tradable variety, a total of 64% was inflation-linked. However, this more-or-less marked a high-water mark. Inflation in Israel was brought under control since the late-1990s. Further, pension reforms in 1995 and 2002 introduced new defined contribution retirement plans that eliminated the need for government support, which was required to prop-up defined benefit plans. In these conditions, use of non-tradable inflation-linked bonds diminished. Still, these comprised 28% of government debt in 2020.
Introduction in Britain
Britain adopted inflation-linked government bonds later than Israel but the U.K. was still the first developed economy to introduce them. The U.K. was plagued by high inflation in the 1970s, inflation which exceeded 20% in 1975 alone. Due to this and growing government borrowing, which had risen from £1.6 billion in 1972 to £8.39 billion in 1975, further borrowing became very expensive. The public deficit was cut during and after the “IMF crisis” of 1976 but yields on government debt did not yield. In 1977, a U.K. government bond with 22-years in remaining term traded hands amongst investors at such a discount that it yielded 15.5%.
In 1978, it was becoming more difficult to place government bonds with investors. By 1980, there were £29 billion in government bonds outstanding with coupons exceeding 10% and terms in excess of 10 years. Long-term borrowing in both the private and public sector became scarce and where it was still being done, was very expensive.
In these conditions, the Wilson Report of 1980 recommended the issuance of inflation-linked bonds. Among the reasons for doing so, it set out that such issuances would support pension funds since they would be particularly interested in assets that mimic the inflation-indexed nature of their liabilities. The rationale also encompassed providing more credibility to the government’s intention to reduce inflation, to increase the ability of the government to borrow despite inflation, and to reduce the net real cost of servicing the debt due to the insurance against rising inflation that the government would be providing.
The recommendation was followed and Britain became the first developed country to issue inflation-linked government bonds on March 27, 1981. Like Israel’s bonds, both the principal and interest payments were linked to inflation. They were issued with a 15-year term and a real, inflation-adjusted, coupon of 2%. At their market prices in the mid-1980s, Britain’s early inflation-indexed bonds carried a real yield of about 3%.
The very first inflation-indexed U.K. government bonds were eligible for purchase by pension funds and life insurance companies only, as they had been in Israel. At £2.98 billion, pension and life insurance buyers made up 55% of government bond purchases in 1976. Beyond their scale, they had particular need for inflation-protected assets so were destined to be interested buyers. The government’s decision to limit purchases to these institutions was partially intended to exclude foreign buyers for fear of triggering an appreciation of the pound due to strong foreign demand.
When inflation did fall, these bonds paid off for the government. In the mid-1980s, the U.K. government was able to issue these bonds with a real yield of 3% at a time when inflation was running at ‘only’ 5%, for a total nominal yield of 8%. This compared to yields on nominal, non-inflation-linked, bonds then yielding around 12-13%.
Eligibility rules that previously limited purchases to pension funds and insurance companies were widened in March 1982. Inflation in Britain then fell after the early 1980s. Nonetheless, demand for inflation-linked bonds did not fall, as in Israel. Instead demand for the bonds grew, particularly in the late-1990s and early-2000s. In 2005, 50-year inflation-linked U.K. government bonds were issued. Inflation-linked securities made up 25% of government debt in 2019, a larger share of government borrowings comprised of inflation adjusted securities than could have been found in any other large advanced economy.
Since 1981
Besides Israel, some other countries preceded Britain in introducing inflation-linked bonds, including Brazil and Finland. Many more countries introduced inflation-linked government bonds after Britain launched its own. These include Australia and Mexico in the 1980s, Canada, Sweden, and New Zealand by the end of 1995, and the United States in 1997.
In the latter country, inflation-linked bonds comprised 6% of government debt at year-end 2020. This is a rather middling proportion compared to other countries with similar government bonds. Not only in Israel and Britan but also in South Africa, Brazil, and Chile, tradable inflation-linked bonds made up over 20% of government debt by the end of 2020. Further, in Turkey, France, Mexico and Colombia, such bonds made up at least 10% of government debt. What was still an experimental concept in 1980 became commonplace by 2020.
Lesson
The experience of Israel and the United Kingdom make clear how a loss of confidence in the enduring value of money can prompt governments to issue, and investors to buy, inflation-linked bonds. These securities can give a second chance to states looking to borrow over longer time horizons. They also better serve certain investors, like pension funds, whose liabilities are inflation-linked. In a way, they better serve these investors than ordinary bonds by creating an alignment of interests between investor and issuer, a desire for low inflation. When investors have trust in the government to keep inflation stable, ordinary bonds may suffice. However, when this trust is lost, an alignment of interests is the next best alternative.
More from the Tontine Coffee-House
Read about inflation-linked notes in colonial Massachusetts and post-war French bonds linked to the price of gold. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts.
Further Reading
1. Brenner, Reuven, and Don Patinkin. “Indexation in Israel.” Inflation Theory and Anti-Inflation Policy, edited by Erik Lundberg, Westview Press, 1977, pp. 387–408.
2. Homer, Sidney, and Richard Eugene Sylla. A History of Interest Rates. Rutgers University Press, 1996.
3. Oliver, Michael J., and Janette Rutterford. “‘The Capital Market Is Dead’: The Difficult Birth of Index‐linked Gilts in the UK.” The Economic History Review, vol. 73, no. 1, 2020, pp. 258–80.
4. Velandia, Antonio, et al. What Is the Role of Inflation-Linked Bonds for Sovereigns? World Bank, Debt Management Facility, 2022.
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