Rates · R9 · 9 min

Inflation-linked bonds and breakevens

Work out the inflation rate the bond market is pricing, say whether an inflation-linked bond or an ordinary one wins, and read the 5y5y.

In the news: “Breakevens jumped after the inflation figures”: the inflation the bond market now expects, and why it isn’t a pure forecast.

The essentials

Inflation-linked bond: A bond whose coupons and repayment are scaled by an : the price index now ÷ its level at issue. UK follow ; US follow CPI.
Real yield: A linker’s is a , earned on top of inflation: one yielding 1.2% real returns about 1.2% a year plus whatever inflation turns out to be.
Breakeven inflation: The inflation rate at which a linker and a conventional bond of the same maturity return the same: a 4.6% against a 1.2% real linker gives 3.4%. Inflation above it favours the linker; below it, the conventional bond.
Not a pure forecast: Breakevens also carry an , which lifts them, and a discount for linkers being harder to sell, which pulls them down when investors rush for cash.
5y5y: The inflation rate priced for years six to ten: about twice the 10-year breakeven minus the 5-year, so a 10-year at 2.8% and a 5-year at 3.0% give 2.6%. Central banks watch it to judge whether inflation will settle at target.
RPI and CPIH from 2030: RPI’s methods are due to be aligned with from February 2030. That is expected to lower RPI inflation, and with it what index-linked gilts pay after that date.

Breakeven inflation

Breakeven = conventional yield − real yield

conventional: yield on the ordinary fixed-payment bond, %
real yield: yield on the matching inflation-linked bond, %

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How it works

1. Inflation eats fixed payments

A bond paying £4 a year buys a little less each year if prices rise 3% a year. An (in the US, ) raises its coupons and the amount it repays in line with prices instead, so inflation doesn’t erode them.

2. The index ratio

Each payment is multiplied by the : the price index now divided by its level when the bond was issued. UK linkers use the . If RPI was 300 at issue and is 375 now, the ratio is 1.25: £1m of the bond now repays £1.25m, and every coupon is 25% bigger.

3. Real yield

Because its payments keep up with prices, a linker’s yield is a : the return on top of inflation. A linker yielding 1.2% returns about 1.2% a year plus whatever inflation turns out to be.

4. Breakeven inflation

A conventional gilt, with fixed payments, yields 4.6%; the matching linker yields 1.2% real. If inflation averages 3.4%, the linker returns 1.2 + 3.4 = 4.6%, the same. That rate is the : the conventional yield minus the real yield.

5. Which bond wins

If inflation averages more than the breakeven, the linker returns more than the conventional bond. If it averages less, the conventional bond wins. Buying a linker instead of a conventional bond is a bet that inflation will beat the breakeven.

6. Not a pure forecast

Investors in conventional bonds want extra pay for the risk that inflation surprises upwards, the , and that lifts the breakeven. Linkers are also harder to sell, so when investors rush for cash they cheapen and the breakeven falls. So a breakeven mixes expected inflation with these effects.

7. 5y5y: where inflation settles

The 5-year breakeven is 3.0% and the 10-year 2.8%. Ten years at 2.8% is the first five at 3.0% plus the next five at about 2.6%, since 2 × 2.8 − 3.0 = 2.6. That rate for years six to ten is the . Central banks watch it to see whether inflation is expected to settle back at target.

8. RPI changes in 2030

RPI’s methods are due to be brought into line with , the official UK inflation measure that includes housing costs, from February 2030. The change is expected to lower RPI inflation, and with it what index-linked gilts pay after that date.

Worked example

5-year gilts yield 4.10% and 5-year index-linked gilts 0.80% real. 10-year gilts yield 4.60% and 10-year index-linked gilts 1.35% real.

5-year breakeven: 4.10 − 0.80 = 3.30%.
10-year breakeven: 4.60 − 1.35 = 3.25%.
5y5y: 2 × 3.25 − 3.30 = 3.20%, the RPI inflation priced for years six to ten.
If RPI averages 3.8% over the next five years, the 5-year linker beats the 5-year gilt by about 3.8 − 3.3 = 0.5% a year.

Breakevens of 3.30% at five years and 3.25% at ten, and a 5y5y of about 3.20%.

Check yourself

8 quick questions on the explanation above.

Practice

New numbers every set. Misses and guesses go into your review deck.

In the interview

Answer out loud in under a minute, then compare.

Who should buy index-linked gilts rather than conventional gilts?
Why might breakevens fall even while inflation is rising?
What’s 5y5y, and why do central banks watch it?

Remember

Breakeven = conventional yield − real yield

If inflation averages more than the breakeven, the linker wins; if less, the conventional bond does.

Next · R10What moves rates: event days

Sources

Definitions and maths are standard textbook material; dated facts link to the sources above. Worked numbers are illustrative.