Why inflation breakevens may not reflect ‘true’ of inflation – part 3

02 May 2023

Inflation-linked bonds are regarded as being relatively illiquid.  But what does this mean?  One nice explanation comes from Barclays Bank

“The reason for the lower liquidity has a lot to do with the product better matching long-term needs than nominals. Partly, the lower liquidity is the price of success for meeting specific needs so well, which means that much less day-to-day trading is needed.”

Reading between the lines they seem to suggest that pension providers with long-term inflation-linked liabilities will hoover up these assets as and when they become available. 

But how is illiquidity represented in the Fisher equation and how is it valued? 

Traditionally, this is captured within the breakeven spread, which is seen to incorporate two ‘risk premium’ components.  One component rewards an investor for the risk of unexpected inflation while a second component is compensation for the degree of illiquidity.  This element of illiquidity would manifest itself as an increase in real yield (therefore a lower price) which would reduce the breakeven spread. 

The main point being that the breakeven spread would fall but not directly as a result of a change in inflation expectations.