This second post will consider the issue of par floors and how they impact real yields. Some sovereign linker markets issue bonds that protect the investor against deflation. Examples include the USA but not the UK.
The redemption proceeds of a linker with a par floor are:
Face value x Max (index ratio, 1)
The index ratio measures the current value of the relevant CPI to the initial value at the point the bond was issued. A value of less than 1 would be indicative of deflation over the life of the issue. If that were to occur, then the investor is repaid par. So the investor is long a put option on the bond.
Looking at the US market, the 3.875% linker of April 2029 is trading at a real price of 139.67 and an index ratio of 1.68 which returns an uplifted nominal value of 235.40. Since this bond was issued, the CPI has increased by about 68%.
Compare that to the more recently issued 0.25% of July 2029. Real price 111.59, index ratio of 1.0689 and an uplifted nominal value of 119.28. This suggests inflation since the time of issue of about 6.8%.
Unless there is a massive decline in the US CPI over the next 8 years, then the index ratio of the 3.875% will stay well above 1 rendering the par floor option worthless. But for the same maturity, the floor for relatively newer 0.25% issue is closer to being ATM.
Market estimates suggest that at the time of writing this note the optionality of the older bond is worthless but for the newer bond it is worth about 0.04% of the nominal value.
So how does an investor pay for the option? Through the real yield. All other things equal a bond whose inflation floor has value will trade at a lower real yield, pushing up the breakeven spread. This would suggest that the increasing breakeven spread is reflecting concerns of deflation, rather than inflation.