analysis
Germany is withdrawing from the market for inflation-protected bonds. This is bad news for private investors looking for safe investment opportunities – or is it?
Boring and not very profitable: this image was attached to inflation-indexed federal bonds for a long time. Advertised by busy bank advisors as safe investments, they yielded little for investors in times of low inflation rates. However, that suddenly changed with the corona pandemic and the Ukraine war. Since then, inflation rates in Germany have skyrocketed – and suddenly made the inflation-indexed federal bond popular.
But now the inflation protection for federal bonds should come to an end. As the German Finance Agency announced yesterday evening, from 2024 onwards, no further inflation-indexed federal securities will be issued or securities already outstanding will be increased. Papers that have already been issued should still be tradable on the market: These four papers have a total volume of 66.25 billion euros and the remaining terms are between around 2.5 and 22.5 years. But why is the federal government now pulling the ripcord on these special federal bonds?
Inflation-indexed Federal bonds cost the federal government billions
The finance agency did not give a reason – but it is obvious: inflation protection has simply become too expensive for the federal government. As early as June 2022, Finance Minister Christian Lindner spoke in this context of “a steep wall that is opening up before us” and pointed the finger at previous governments that had issued inflation-protected government bonds. “We used to make money there, but now we’re paying billions for it.”
In 2022, as a result of high inflation, the federal government set aside an additional 2.2 billion euros for a fund from which the inflation-indexed federal bonds were repaid. This emerges from a document from the Bundestag’s budget committee, which the Reuters news agency saw.
If the state does that Inflation risk takes over
But where do these high costs come from? To do this, you have to understand how an inflation-indexed federal bond works. In financial jargon, such bonds are also referred to as “linkers” – short for “inflation-linked bonds”. This is a highly complex financial product. The aim is to offer the investor a fixed real interest rate. The real interest rate is the nominal interest rate minus the inflation rate.
The coupon, i.e. the interest on the bond, is fixed. So far, so ordinary. But with an inflation-indexed federal bond, the coupon is multiplied by a coefficient that reflects the development of inflation, the so-called “index ratio”. If inflation rises, the “index ratio” increases – and with it the actual interest payment. With a linker, the issuer, in this case the German state, assumes the inflation risk that would otherwise lie with the investor.
Inflation protection with hook
But the built-in inflation protection has a catch: for linkers to be worthwhile, actual inflation must exceed market participants’ inflation expectations. Only then did investors do good business with inflation-protected bonds. If inflation is below expectations, traditional bonds would have been the better choice.
After the end of inflation-indexed federal bonds, there are still alternatives for private investors who are interested in protecting against inflation. Other countries, for example in the Eurozone or the USA, continue to issue such special government bonds. Anyone who is interested in this form of investment can use it, but should take the special conditions into account.
ETF, stocks and real estate as alternatives for investors
There are also actively managed pension funds that invest in several inflation-protected government bonds worldwide and thus spread the risk. If you want it cheaper, you can also use appropriate ETFs – such as inflation-protected US bonds. Here it is important to consider the currency risk.
However, inflation-indexed bonds do not offer perfect protection against inflation due to their special calculation method. An investment in this highly complex financial product is only worthwhile under very specific conditions. Anyone looking for inflation protection will continue to find it in real assets such as real estate and stocks.