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CP1 Chapter 8 IL Bonds

A

AKS01

Very Active Member
Hi,

Chapter 8 page 20 says that greater uncertainty in the economic market around inflation will increase the demand for Index Linked securities as it offers protection against unexpected inflation. I understand it protects against inflation as the income and final payment will be linked to an inflation index, but would it only increase demand if investors thought inflation was going to increase?
 
Hi ASK01

All other things being equal, if investors (who generally have real liabilities) expect higher inflation than before, demand for index-linked bonds will go up, pushing the price of these up.

However, it's not just this expectation that affects demand in this way. If there's increased uncertainty about what will happen with inflation, so that forming expectations of future inflation is more difficult, then there's a greater risk that inflation will be higher than expected so that cashflows from assets that aren't inflation linked won't be high enough to cover (inflation linked) liability outgo in future (given we are less sure about what is going to happen with inflation). (This uncertainty, for example, could be the result of increased volatility of inflation being expected, so that it's more difficult to predict.) The greater this risk is, the more likely it is that investors with real liabilities will buy index-linked securities, increasing the demand of, and hence the price for, these.

I hope this helps.
 
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