The harbingers of inflation are unmistakable: Rising oil prices, a continuing global recovery and unrelenting growth in China. Investors--concerned about the impact of inflation--are more interested than ever in inflation-linked bonds (ILBs) as an investment that may preserve their future purchasing power.

As demand for ILBs has grown, so has supply. Issuers of global inflation-linked bonds continue to enter the market, seizing the opportunity to restructure their funding strategies to better match their revenue streams. This unprecedented enthusiasm for ILBs among issuers and investors has led to a burgeoning global market that has more than tripled in size over the last six years, growing from $145 billion in 1997 to $551 billion at the end of 2003. While the United Kingdom retains its status as the first major issuer of ILBs, it has been joined by a multitude of major global issuers including: Australia, Canada, Sweden, U.S., France, Italy, Greece, Japan and soon perhaps Germany.

ILBs can offer an attractive situation for investors and for the governments that issue them. Investors, especially those with liabilities that rise with inflation, can benefit from the hedge against an unexpected rise in inflation that ILBs can provide. Governments benefit because investors pay a premium for the inflation protection provided by ILBs, allowing governments to borrow more cheaply. Governments that issue ILBs also signal that they are inflation fighters, which can result in lower nominal interest rates and lower government borrowing costs.

A Brief History of Inflation-Linked Bonds
The concept of inflation-linked bonds can be traced back to 1780, when the Massachusetts Bay Company sold a precursor bond that was tied to the price of beef, shoe leather and other staples. The strategy didn’t catch on, however, and lay dormant until 1950 when Iceland sold inflation-linked bonds to address 15% inflation--a concern that quickly dissipated when inflation dropped to zero the following year. In 1981, the modern inflation-linked bond market began when the United Kingdom leveraged thestrategy with a £1 billion sale. Shortly thereafter, the trend caught on and Sweden, Canada and Australia also issued inflation-linked bonds. In 1997, the U.S. entered the market with its first auction of Treasury Inflation-Protected Securities, often referred to as "TIPS."

Since then, the global inflation-linked bond market has grown rapidly and new countries continue to regularly enter the field--in 2003 Greece and Italy held their first offerings, and in 2004 Japan made its first issuance. Today’s mainland European inflation-linked bond market, third in size after the U.S. and U.K., accounts for over $150 billion of the overall global market. (Please see the Appendix for further details regarding the major global issuers of inflation-linked bonds and the role each plays in the ILB market.)

How Inflation-Linked Bonds Work
All ILBs are tied to inflation although the precise provisions vary around the world. In the U.K., for example, outstanding principal is adjusted in response to changes in the Retail Price Index. In general, the interest payments and principal on an inflation-linked bond rise along with any widespread increases in consumer prices so that the bond’s cash flows increase with a corresponding rise in inflation.

If you have, for example, a $1,000 10-year inflation-linked bond with a 2.0% annual real coupon purchased in 2005--in an environment of 3% hypothetical annual inflation--the interest paid would be 2.0% of $1,000, or $20.00. The principal on the bond adjusts upward on a daily basis to match the inflation rate, reaching $1,344 at the end of 10 years. Although the coupon rate on the bond remains fixed at 2.0%, the actual interest payments rise as the value of the principal increases and in 2015, the annualized interest payment would be 2.0% of the inflation-adjusted principal, or 2.0% of $1,344, which is $26.88. The note would then be redeemed at maturity for $1,344.

While the nominal amount of interest paid on an inflation-linked bond may rise over time, the real value of the interest and principal of an inflation-linked bond actually remains constant. In the above example, the purchasing power of $26.88 in 2015--which is the final interest payment on the bond--would be the same as the purchasing power of $20 in 2005--the initial interest payment. Similarly, the $1,344 received at maturity will purchase the same amount of goods or services, in 2015, as the $1,000 principal purchased in 2005. Thus, inflation-linked bonds are valuable in providing recurring real cash flows to investors by protecting against inflation.

The Rise of Global Inflation-Linked Bonds
Although ILBs are not new, they were largely undervalued prior to the 1997 issuance of TIPS by the U.S.--an event that coincided with a period of renewed interest in asset-liability matching. With the success of the TIPS issuance, several new countries issued ILBs and the inflation-linked bond market began to build on its own success.

Inflation linked bonds are attractive to investors seeking asset-liability management because they can serve as a better inflation hedge than equities by providing predictable real returns even when inflation rises abruptly. For example, the correlation between European ILBs and European inflation is much higher than the correlation betweenEuropean equities and European inflation over both one-year and five-year periods, as the table below illustrates.

Correlation of Assets to EUR Inflation

Source: Global Financial Data, PIMCO. Not indicative of past or future performance of any Allianz Global Investors product.

Additionally, as the global inflation-linked bond market has grown, so have the opportunities to potentially generate alpha from a diversified asset class that possesses unique performance characteristics. European ILBs, for example, have had a low or even negative correlation to other major asset classes, as the chart below illustrates.

Correlation of Assets to European ILBs, 1900-2003*

Source: Global Financial Data, PIMCO. Not indicative of past or future performance of any Allianz Global Investors product.

*Based on annual returns. For years ended 1900 through 1999, ILB Total Returns were calculated by estimating price returns and real coupons along with inflation data. Price returns were estimated from the monthly change in 10-year constant maturity treasury yield and an assumed yield beta of 0.6. Real coupons were based on average nominal yield less trailing three-year inflation, from 1900-2003, which averaged -2.17%. Monthly inflation accruals were based on monthly changes in the French CPI index. From Dec. 1999 through 2003, ILB Total Returns are represented by the Barclay’s Euro Government Inflation Linked Bond Index. European equity is the France SBF-250 Total Return Index. European 10-year bonds are represented by the France 10-year Total Return Government Bond Index. European T-Bills are represented by the France Total Return Bills Index

Benefits of Issuing Inflation-Linked Bonds
Countries have sought to meet the increased demand from investors for inflation linked-bonds while also utilizing them as sophisticated fiscal instruments. Governments that issue ILBs may benefit from:

• Liability diversification with the potential to match future real liabilities (from the cash-flow due to bond holders) to assets from future real revenue (represented by the government’s tax income);
• Lower borrowing costs due to the premium investors are willing to pay for inflation protection; and
• The opportunity to send a message that they intend to stem the tide of inflation--an action that may also result in lower borrowing costs and potentially lower nominal interest rates.

Inflation-Linked Bonds Versus Nominal Government Bonds
While interest payments on an inflation-linked bond will decline during periods of decreasing inflation or deflation most issuers guarantee that a bondholder will receive at least the face value of the bond at maturity. And while ILBs fluctuate with changes in real interest rates, they do not contain an expected inflation component as nominal bonds do. ILB yield is determined by real yield and the risk premium while nominal bonds also fluctuate based upon changes in inflationary expectations. For these reasons, ILBs are considered "real return" bonds.

The difference in yields between ILBs and nominal government bonds--relative to the actual rate of inflation--is called the breakeven inflation rate. If a 10-year nominal government note yields 4.4%, for example, and a 10-year ILB note yields 2.4%, then the breakeven inflation rate is 2%. When the breakeven inflation rate is less than the actual rate of inflation for the period to maturity, ILBs should provide a higher total return than the nominal bond. As the table below illustrates, breakeven inflation rates in major ILB markets reflect low expectations for future inflation.

Source: Bloomberg Financial Markets, Barclay's Capital

*Data as of 9/30/04. ** U.K. linkers are indexed to the Retail Price Index instead of the Consumer Price Index. This table is not indicative of past or future performance of any Allianz Global Investors product.

Conclusion
Inflation-linked bonds return inflation plus a real return making their long-term performance less uncertain than that of other asset classes, including conventional bonds. Since ILBs provide more certain returns than nominal bonds, they may provide an investment strategy that fits with asset-liability matching for both investors and issuing countries. Also, since ILBs have a low correlation to stocks and other bonds, their introduction into a portfolio may help manage overall volatility. And with more countries issuing ILBs, there is increasing diversity within the asset class and additional opportunities to potentially generate alpha.