Investment portfolios struggle to fully hedge against inflation risk
A new DNB working paper finds that investment portfolios face inherent limits in hedging against inflation risk. Inflation-linked bonds offer only limited protection, with nominal debt and stocks playing comparable roles.
Real basis risk limits hedging effectiveness
A new DNB working paper empirically demonstrates that inflation-linked bonds (ILBs) offer only limited protection against inflation risk in investment portfolios.
The study, covering the Netherlands, Germany, the United Kingdom, and the United States, finds that nominal debt and stocks play at least comparable roles in hedging real returns.
These findings hold true for both static and dynamic investment settings.
The authors attribute this limited effectiveness to real basis risk, which arises from mismatches between the inflation rate to be hedged and the protection offered by available instruments.
This includes factors like differing inflation measures, limited instrument durations, and the absence of domestic ILBs in some countries, such as the Netherlands.
The implications are particularly relevant for long-term investors like pension funds, who aim to protect the real value of their participants' benefits over extended horizons.
Pension funds seek stable real returns
The resurgence of inflation after the Covid-19 crisis has made protecting the real value of investments a critical concern for long-term investors, especially pension funds.
These institutions aim to provide stable purchasing power for their participants, but effective long-horizon inflation hedging faces significant challenges.
Market frictions, rollover risks, and the limited availability of suitable instruments complicate this task.
For instance, many countries, including the Netherlands, do not issue inflation-linked bonds (ILBs) tied to their domestic price index.
This forces local pension funds to use foreign ILBs, which represented only 1 percent of their total asset holdings in 2024.
While other assets like equities offer some hedging, these are often imperfect and incur additional costs.
Hedging's hard truth
This study delivers a crucial, albeit sobering, message for pension funds and other long-term investors: true inflation protection remains elusive with current market instruments.
The findings highlight a significant market incompleteness, particularly concerning the supply of effective inflation-linked assets.
Policymakers should consider these limits when evaluating the need for enhanced hedging instruments to support financial stability and retirement security.