KEY TAKEAWAYS
- The breakeven inflation rate is the difference between the nominal yield of a conventional bond and the real yield of an inflation-linked bond of the same issuer with the same maturity.
- It is recommended to buy inflation-linked bonds only if the potential investor expects a higher inflation rate than expressed by the current breakeven inflation rate.
- The 10-year breakeven inflation rate also indicates the current inflation expectations of the market for the next 10 years on average per year and is therefore generally regarded as a gauge of future inflation.
The breakeven inflation rate indicates how high the inflation rate must be for the purchase of an inflation-linked bond to yield at least the same real return for the investor as the purchase of a conventional bond. The breakeven inflation rate is therefore the inflation rate at which neither a conventional bond nor an inflation-linked bond is more profitable. In the case of inflation-linked bonds, inflation must reach a certain level for the purchase of these bonds to be worthwhile compared with conventional bonds, or at least for the investor not to be worse off. This rate is called the breakeven inflation rate and shows the difference between the real yield of an inflation-linked bond and the nominal yield of a comparable, traditional bond.
Calculation
To determine the breakeven inflation rate, the yield of a traditional government bond is compared with the yield of an inflation-linked government bond. If a traditional US government bond (maturity 5 years) yields 3 % and a US inflation-linked government bond with the same maturity yields 1 %, the breakeven inflation rate is currently 2%. This is now the inflation rate expected by the market at this point in time per year for the next 5 years and at the same time the inflation rate that must be exceeded on average per year so that the purchase of the inflation-linked bond was more profitable than the purchase of the classic bond. If inflation was actually above the 2 % per year expected by the market, then the purchase of the inflation-linked bond was more profitable than the purchase of a conventional bond. However, if the inflation rate was only 1.5 %, then buying the inflation-linked bond was not worthwhile and the investor would have made more money with a conventional bond. The decision on which type of bond to invest in therefore depends on the investor’s inflation expectations compared with the market.
Market Expectation
For example, if the investor expects inflation to be 3.5 % per year until the inflation-linked bond matures, but the breakeven inflation rate at that time is only 2 %, it makes sense for the investor to buy the inflation-linked bond. Thus, for potential investors, the actual inflation rate must be higher than the current breakeven rate (the market’s expected inflation rate) in order to make more money with an inflation-indexed bond. Conversely, investors should not buy inflation-linked bonds if they expect inflation to be lower than currently expected by the market and reflected in the breakeven inflation rate. Because then an investment in conventional government bonds would be more profitable due to the higher coupon payments.
Market expectations of inflation often rise in tandem with market expectations of rising economic growth rates. In addition, a sustained expansionary monetary policy can lead to higher inflation expectations.
Misinterpretation
However, the breakeven inflation rate can also be misinterpreted. This can happen if demand for inflation-linked bonds increases significantly due to a falling interest rate level, which would lead to a lower real yield but would make it appear that the market expects higher inflation. The yield differential between inflation-linked bonds and conventional bonds would then widen. If the volume of inflation-indexed bonds is low, a liquidity premium demanded by the market may also lead to a distortion of the breakeven inflation rate. In this case, this would reduce the breakeven inflation rate but it would not reflect the market’s actual inflation expectations.