In the debt market, fixed-income bonds have traditionally been the most popular instruments, with standardized methods for risk assessment and yield forecasting. However, even with these established tools, market forecasts often fall short, as global economic events and market volatility can disrupt expectations.
Beyond traditional fixed-rate bonds, instruments with floating coupon rates (known as “floaters”) have gained popularity, theoretically reducing interest rate risks. However, in practice, these bonds are still exposed to interest rate volatility due to external factors, such as liquidity regulation changes and rising credit spreads, which can impact the attractiveness and value of earlier issues.
Index-Linked Bonds: Characteristics and Challenges
In addition to conventional instruments, more complex products, like index-linked bonds, have emerged, including inflation-linked bonds (“linkers”) and gold-linked bonds. These products consist of two revenue components: a fixed coupon, which compensates for risks, and a variable component linked to inflation or gold prices. Due to this structure, their returns often depend on indexation, making their investment prospects uncertain.
Inflation-Linked Bonds: Risks and Volatility
Inflation-linked bonds, or linkers, adjust the principal based on inflation. In Russia, OFZ-IN bonds protect investors against currency devaluation, making them attractive for long-term investments. However, in periods when the central bank’s rate significantly exceeds inflation, these bonds may underperform relative to other investments. Key components of linkers’ returns include accrued inflation, coupon payments, and principal revaluation, with inflation expectations (or “implied inflation”) playing a critical role in assessing linkers.
For example, the yield trends of OFZ-PD 26212 (a fixed-rate bond) and OFZ-IN 52002 (an inflation-linked bond) have mirrored each other, indicating competition between these alternative investment options. With market inflation expectations around 7%, investing in linkers is profitable when inflation expectations are low. However, recent increases in real yields have triggered a sell-off in linkers, causing price declines in recent months.
The chart comparing OFZ-PD 26212 (“fixed”) and OFZ-IN 52002 (“linker”) shows a strong trend in yields for both bonds, reflecting market interest rate dynamics. This symmetry suggests that inflation protection does not fully insulate linkers from interest rate changes. Historically, Russia’s central bank kept its policy rate about 2-3% above inflation, which enabled linkers to compete with fixed-rate bonds. But over the past year, rates have risen significantly above inflation, resulting in lower yields on linkers.
Calculating Implied Inflation and Real Yields
To estimate implied inflation, one can look at similar-maturity bonds. For example, OFZ-IN 52002, with a real yield of 12.35%, and OFZ-PD 26212, with a nominal yield of 20.14%, reflect an implied inflation rate of approximately 7.79%. In other words, the market expects an average inflation rate of 7.79% over the remaining maturity of OFZ-IN 52002. If actual inflation falls short, the fixed-rate OFZ-PD 26212 would outperform, as its nominal yield exceeds the combined real yield and expected inflation of OFZ-IN 52002.
Gold-Linked Bonds: Characteristics and Outlook
Gold-linked bonds represent an even more complex variant of index-linked securities. An example is the series of bonds issued by the mining company Seligdar, whose principal is tied to the ruble-denominated gold price, adjusted with a three-day lag. These bonds offer a low coupon rate of 5.5%, as they aim to provide returns through ruble price increases of gold, potentially benefiting from ruble depreciation or rising global gold prices.
Despite gold’s rally, up over 50% since Seligdar’s first gold-linked bond issuance in May 2023, these bonds have declined significantly since April, with SELGOLD001 down 20 points, SELGOLD002 down 24 points, and SELGOLD003 down 15 points. This decline can be attributed to interest rate risk, which has similarly impacted inflation-linked bonds. Higher nominal and real interest rates have diminished their appeal, pushing investors toward more predictable alternatives.
For Seligdar’s gold-linked bonds, returns are based on the projected gold price performance over the bond’s life, along with a risk premium for credit risk due to the company’s credit rating. Historically, the G-spread for Seligdar’s bonds has averaged around 250-300 basis points, which is factored into the bond’s expected return equation: YTM (yield to maturity) + risk premium (G-spread) = YTM0 (coupon-based yield) + E(R) (expected gold return).
For example, if OFZ-PD 26212 serves as a benchmark with a 20.14% yield to maturity, adding a 2.5% credit spread for Seligdar’s bonds, we estimate an implied gold return of around 12-13%. Over the past decade, the ruble-denominated gold price has grown by approximately 18% on average, suggesting potential undervaluation of these bonds. However, recent gold market dynamics have cast doubt on the sustained high performance of gold, which might explain investors’ hesitancy.
Key Takeaways
Bonds indexed to volatile metrics like inflation or commodity prices present unique challenges for investors. These instruments are vulnerable to interest rate volatility, making their valuation and performance unpredictable. Under normal macroeconomic conditions, stable or low real interest rates would generally reduce interest rate risk. However, with today’s high rates, these bonds have experienced a loss in value. For instance, until 2023, linkers consistently outperformed money market rates, but the economic landscape shifted in 2023, impacting the returns of inflation-linked and gold-linked bonds alike.
Seligdar’s gold-linked bonds have also been hit hard despite gold’s rally, mirroring the trends seen in the U.S. market. Treasury Inflation-Protected Securities (TIPS) faced similar losses, showing that even inflation-protected instruments are not immune to rising rates. Over the past year, TIPS returns decreased by 7.1%, with a 1.7% loss over the last two years.
As a result, Russian index-linked bonds—both inflation- and gold-linked—remain high-risk, volatile investments in the current high-interest-rate environment. While they offer protection against inflation and currency depreciation, significant interest rate risks may continue to challenge their appeal until a more stable economic environment returns.
