Inflation as a determinant of South African inflation-linked bond returns

Van Zyl, Jaco (2015-04)

Thesis (MDF)--Stellenbosch University, 2015.


ENGLISH ABSTRACT: “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.” – Ronald Reagan It is widely publicised that inflation-linked instruments provide a hedge against rising inflation. This has led investors to assume that high inflation creates an opportunity to beat the market when investing in this asset class. This assumption is based on the belief that higher inflation creates higher returns. It is due to this belief that a research question was formulated to determine if inflation is in fact a determinant of inflation-linked bond returns. This research study investigated, as a first objective, the relationship between the South African prime lending interest rate and the South African consumer price index inflation between 2000 and 2013. The Augmented Dickey-Fuller test was applied to test for unit roots between interest and inflation. This test was extended to six other emerging countries that, together with South Africa, are issuers of government inflation-linked bonds. The researcher’s intention was to compare the relationship between interest rates and inflation in South Africa with that of the six other countries. Surprisingly, the results indicated that South African inflation and interest are non-stationary. After testing for cointegration, it was concluded that there is no relationship between the prime lending interest rate and inflation in the data set and most of the variation can be explained by means of the autocorrelation of residuals in previous periods more than the prime lending rate. As a second objective, the same methodology was applied to determine whether there is any relationship between the South African consumer price index inflation and the South African government inflation-linked bond returns. The results indicated that the series is not cointegrated which means that no relationship exists between inflation and inflation-linked bond returns. The third objective looked at alternative factors that could explain what the real determinants of inflation-linked bond returns are. It was concluded that the trend in inflation is really the source of inflation-linked bond performance, with the effects of the lead and lag periods causing capital losses and profits.

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