A reference guide to inflation-linked bonds the nuts and bolts of fixed income managemen pdf

inflation-linked bonds
the nuts and bolts of
fixed income management
Goldman Sachs Asset Management I 1
Contents
½
What are inflation-linked bonds? 2
½
What are TIPS? 3
½
Comparing inflation-linked bonds and conventional bonds 4
½
Understanding breakeven inflation 5
½
Volatility in inflation-linked bonds 6
½
What are the potential benefits of inflation-linked bonds? 7
½
What are some of the main risks of inflation-linked bonds? 8
½
Conclusion 9
½
Behind the industry jargon 10
½
Learn more 11
Introduction
Fueled by growing inflation concerns and attractive prices,
particularly relative to nominal bonds, investors poured money into
inflation-linked bonds in 2009. In the US, investors believe
unprecedented fiscal and monetary stimulus will lead to more US
dollar depreciation and higher inflation. In the UK, investors fear

the Bank of England’s reluctance to raise rates will fuel inflation.
While inflation has been muted in recent years, it remains a
concern for pension funds, endowments and other institutional
investors who must meet real, rather than nominal, liabilities.
Inflation-linked bonds, such as US Treasury Inflation-Protected
Securities (TIPS) and UK inflation-linked Gilts, can help hedge this
risk because their principal is adjusted to reflect changes in
inflation. In addition to the embedded inflation protection, these
bonds offer other potential benefits to an investment portfolio.
In this reference guide is an overview of the $1.5 trillion inflation-
linked bond market, as well as a closer look at how these
securities react to changing market conditions over short- and
long-term periods.
This material is provided for educational purposes only and should not be construed as
investment advice or an offer or solicitation to buy or sell securities.
2 I Goldman Sachs Asset Management
TIPS represent the largest slice of the global inflation-linked bond
market, and all these securities share the same general structure.
The US Treasury issues TIPS in 5- to 30-year maturities. The
principal is adjusted upward or downward each month based on
changes in the Consumer Price Index (CPI-Urban, non-seasonally
adjusted with a three month lag). The coupon rate remains fixed,
but since it is applied to the inflation-adjusted principal, the semi-
annual interest payments increase or decrease accordingly.
The chart below illustrates the structure of a hypothetical inflation-
linked bond issued with a principal of $100 million, a coupon rate of
3% and a maturity of three years. The example shows what
happens to the value of the principal and coupon payments when
inflation in successive years is 2%, 3% and 0%, respectively.
Hypothetical Inflation-Linked Bond Structure

Goldman Sachs Asset Management I 3
What are inflation-
linked bonds?
Inflation-linked bonds, sometimes known as “linkers,” are high-
quality securities issued mostly by governments that provide
income and total return which adjusts to keep up with the pace of
inflation. The global inflation-linked bond market has more than
doubled in size since 2003 amid rising investor demand, and today
there is also a fledgling market in inflation-linked corporate bonds.
The UK was the first major market to issue these bonds in 1981,
and they now represent approximately 23% of the UK’s total
outstanding debt. US TIPS assets have grown to $560 billion since
they were first issued in 1997 and have been a key source of
growth in the marketplace.
1
Since their debut, inflation-linked
bonds have generally performed as expected over long time
periods; that is, they have moved in step with rising prices. Of
course, because inflation-linked bonds are a relatively new
investment, they have not yet had the opportunity to prove their
mettle during periods of high inflation or hyperinflation.
Inflation-Linked Bond Market at a Glance
Total Nominal
Country Total ILBs Nominal Bonds
(year of first ILBs % Wgt of Total Bonds % Wgt of Total
issuance) ($billions) Outstanding Debt ($billions)* Outstanding Debt
US (1997) $560 12% $4,154 88%
UK (1981) $353 23% $1,160 77%
France (1998) $222 16% $1,125 84%
Italy (2003) $132 9% $1,382 91%

Japan (2004) $71 1% $5,101 99%
Canada (1991) $42 13% $292 87%
Germany (2006) $41 3% $1,214 97%
Sweden (1994) $35 30% $79 70%
Greece (2003) $22 7% $317 93%
Australia (1997) $10 12% $78 88%
Totals $1,488 9% $14,902* 91%
Source: Merrill Lynch, as of 10/31/09. *Excludes bills.
What are
TIPS?
1
Source: Merrill Lynch, as of 10/31/09.
This information discusses general market activity, industry or sector trends, or other broad-
based economic, market or political conditions and should not be construed as research or
investment advice. Please see additional disclosures.
Principal = $100 million
$100
$102
$105.06 $105.06
Year 0 1 2 3
Inflation Rate 2% 3% 0%
Coupon $3.06 $3.15 $3.15
Payments (at 3%)
Redemption Value $105.06
Total Cash Flows $3.06 $3.15 $108.21
Simulated results do not reflect actual trading and have inherent limitations. Please see
additional disclosures.
Goldman Sachs Asset Management I 54 I Goldman Sachs Asset Management
To understand how TIPS work, it’s important to note how their
construction differs from traditional Treasuries. With a Treasury, the

market prices in three sources of return: the real yield, an additional
yield to compensate for expected inflation, and an inflation risk
premium. The latter two components are the additional cost that
buyers and sellers factor in to account for the uncertainty of
inflation. By contrast, the return on TIPS has two sources of yield:
the real yield and a yield representing actual trailing inflation. TIPS
are unique in that their real yields are clearly identifiable, and they
provide a predictable real return.
The difference in yield between inflation-linked bonds and
conventional bonds, also known as the breakeven inflation rate
(BEI), is a rough measure of inflation expectations. Breakeven
inflation encompasses both the expected inflation rate and the
inflation risk premium, two components of nominal yields that on
their own are not always easily quantifiable.
Put another way, breakeven inflation is the future inflation rate
required for a real bond to achieve the same return as a comparable
nominal bond, if held to maturity. If actual inflation is more than
breakeven inflation, a real bond is likely to outperform the nominal
bond. If actual inflation is less than breakeven inflation, the nominal
bond is likely to outperform. Of course, in either scenario, a central
bank may respond by lowering or raising rates to keep inflation in
check. Breakeven inflation is only a rough measure because a
number of factors can influence it, including liquidity and supply
and demand.
Breakeven Inflation: the Market’s Views on
Rising Prices
Understanding
breakeven inflation
For illustrative purposes only.
Inflation Risk

Premium
Expected
Inflation Rate
Real
Yield
CONVENTIONAL
BOND YIELDS
If actual inflation Ͻ
breakeven inflation
Conventional bonds
may outperform
Actual
Inflation
Real
Yield
INFLATION-LINKED
BOND YIELDS
If actual inflation Ͼ
breakeven inflation
Inflation-linked bonds
may outperform
Breakeven
Inflation
This information discusses general market activity, industry or sector trends, or other broad-
based economic, market or political conditions and should not be construed as research or
investment advice. Please see additional disclosures.
Comparing inflation-
linked bonds and
conventional bonds
Actual

Inflation
Real
Yield
INFLATION-LINKED
BOND YIELDS
For illustrative purposes only.
Inflation Risk
Premium
Expected
Inflation Rate
Real
Yield
CONVENTIONAL
BOND YIELDS
• Consistency of breakevens with inflation outlook in medium term
• Levels of breakevens relative to central bank inflation targets
• Levels of risk premiums associated with breakevens
• Liquidity factors
• Risk appetites
• Supply and demand pressures on swaps
• Relationship between breakevens and nominal yields
• Historical trading patterns
• Valuation of real yields and breakevens given near term
inflation outlook and seasonality
• Effect on curve and levels of breakeven
6 I Goldman Sachs Asset Management Goldman Sachs Asset Management I 7
TIPS and other inflation-linked government bonds have been hailed
as a solid choice for pensions paying inflation-indexed benefits,
endowments seeking to preserve purchasing power and other
institutional investors whose task of asset/liability matching has

grown increasingly challenging. Because they are issued by
governments, they have minimal credit risk. They have less volatility
than stocks and other inflation-hedging investments such as
commodities or currencies. They also have a low correlation to major
asset classes, although they are more correlated to nominal bonds
when interest rates are low. Given their predictable real return,
inflation-linked bonds may be a more reliable way to protect against
inflation than equities, especially in cases of unexpected inflation.
TIPS: Low Correlation
Inflation-linked bonds have a low correlation to many other asset classes.
What are the
potential benefits
of inflation-linked
bonds?
A big issue for investors is that inflation-linked bonds are not
always held to maturity. Real yields of inflation-linked bonds can
and do change; they can be volatile just as the yields of
conventional bonds are volatile. Real yields are influenced by many
factors, including fiscal and monetary policy, supply and demand,
liquidity and the level of economic growth. For this reason,
inflation-linked securities can deliver positive returns when inflation
is flat or even falling. For example, TIPS returned 13.9% in 2009 as
of November 30 while CPI was down 0.2% year-over-year as of
October 31. In the UK, inflation-linked Gilts returned 24.4%, with
the Retail Prices Index (RPI) down 0.8% year-over-year, during the
same time periods.
2
Key Performance Drivers of Inflation-Linked Bonds
Volatility in inflation-
linked bonds

Economic
valuation
Supply and
demand
dynamics
Relative
valuation
Near term
carry
prospects
2
Source: Barclays. TIPS represented by the Barclays US Tips Index and UK linkers
represented by the Barclays UK Inflation-Linked Index.
This information discusses general market activity, industry or sector trends, or other broad-
based economic, market or political conditions and should not be construed as research or
investment advice. Please see additional disclosures.
Source: Barclays, as of 10/31/09. US TIPS represented by the Barclays US Govt Inflation-Linked
Bond All Maturities Index. Nominal bonds represented by the Barclays US Govt Break-Even
Inflation-Linked Bond All Maturities Index, which provides a simple framework for comparing
returns on an inflation-linked bond market with a nominal bond market. The Break-Even index
includes nominal bonds that are maturity-matched with an inflation-linked bond index, which
provides a much better comparison of relative performance than comparing a linker index with a
conventional bond market index.
0
5
10
15
20
25
30

35
GSCI
S&P 500
US Nominals
US TIPS
Annualized Standard Deviation (%)
1999 2000 2002 2004
2006
20082001 2003 2005 2007 2009
S&P 500 0.29
MSCI EAFE 0.33
Barclays US Aggregate 0.74
Barclays US High Yield 0.43
(2% constrained)
GSCI Commodities 0.34
TIPS: Less Volatility
TIPS have been less volatile than other asset classes over the long term but have
demonstrated short-term volatility since 2008.
Source: Goldman Sachs Asset Management.
Source: Bloomberg, 5-year correlation of Barclays U.S. TIPS Index as of 10/31/09.
Goldman Sachs Asset Management I 9
Regardless of how inflation moves in the near term, history has
shown that spikes in inflation can occur without warning,
particularly after long periods of low inflation. Thus, the best time
to hedge a portfolio against inflation can be before it starts rising.
Investors looking to employ inflation-linked strategies in their
portfolios should understand how these securities react to changing
market conditions over shorter periods. Inflation-linked bonds have
proved to be volatile over the near term, and positive performance
may follow periods of low or negative inflation, and vice versa. An

active manager can help identify the most attractive opportunities
within this unique market segment and help mitigate issues with
liquidity and cost.
8 I Goldman Sachs Asset Management
Conclusion
Besides potential for short-term volatility, interest payments of
inflation-linked bonds will decline in a deflationary environment,
although investors in most countries will receive the full principal if
they hold the bonds to maturity. For example, the US and France
guarantee a “deflation floor” in which they will repay the initial par
value at maturity, no matter what the inflation environment. Below
are some of the other main risks of inflation-linked bonds:
½
Index-based risk:
The risk that the given inflation index mis-
measures the actual increase in prices of goods and services
that the bond holder is trying to hedge, or that the index
computation will be altered in a way that is adverse to the
interests of the bond holders. This can influence the breakeven
rate in periods of very volatile inflation.
½
Liquidity risk:
Inflation-linked bonds are generally less liquid
than comparable nominal bonds, which may raise real yields.
½
Yield risk:
Inflation-linked bonds may not perform as well in a
rising interest rate environment. When a central bank starts
raising rates, real yields are likely to rise and the prices of
inflation-linked bonds are likely to decline.

What are some of the
main risks of inflation-
linked bonds?
This information discusses general market activity, industry or sector trends, or other broad-
based economic, market or political conditions and should not be construed as research or
investment advice. Please see additional disclosures.
Behind the
industry jargon
Goldman Sachs Asset Management I 1110 I Goldman Sachs Asset Management
Breakeven inflation
The difference between real and nominal bond yields, including
both the expected inflation rate and the inflation risk premium. It is
a rough measure of the market’s inflation expectations.
CPI
The Consumer Price Index (CPI) is a measure of the average change
over time in the prices paid by urban consumers for a market basket
of consumer goods and services.
Deflation
A sustained, broad-based decline in the price of goods and services.
Inflation risk premium
The additional yield that bond buyers demand to take on the risk of
inflation.
Linkers
A general name for any bonds issued by governments whose
principal and interest are adjusted to reflect changes in inflation.
Nominal yield
The yield of a conventional bond, which includes the real yield, the
expected inflation rate and an inflation risk premium.
RPI
The Retail Prices Index (RPI) measures the level of retail prices in

the UK.
Real return
The return on an investment that is adjusted to reflect changes in
inflation.
This information discusses general market activity, industry or sector trends, or other broad-
based economic, market or political conditions and should not be construed as research or
investment advice. Please see additional disclosures.
Following is a list of GSAM publications that can help you further
explore and expand your understanding of fixed income investing.
½ Derivatives
½ Mortgages, bank loans and structured credit
½ Corporate credit
½ Currencies
½ Commodities
Please contact your relationship management team
to obtain a copy of these materials.
Learn more
Disclosures
This information may not be current and GSAM has no obligation to provide any updates or
changes. With specific regard to the distribution of this document in Asia ex-Japan, please
note that this material can only be provided, upon review and approval by GSAM AEJ
Compliance, to GSAM's third party distributors (for their internal use only), prospects in
Hong Kong and Singapore and existing clients in the referenced strategy in the Asia ex-
Japan region. This presentation has been communicated in Canada by GSAM LP, which is
registered as a non-resident adviser under securities legislation in certain provinces of
Canada and as a non-resident commodity trading manager under the commodity futures
legislation of Ontario. In other provinces, GSAM LP conducts its activities under exemptions
from the adviser registration requirements. In certain provinces GSAM LP is not registered
to provide investment advisory or portfolio management services in respect of exchange-
traded futures or options contracts and is not offering to provide such investment advisory or

portfolio management services in such provinces by delivery of this material. This material
has been issued or approved for use in or from Hong Kong by Goldman Sachs (Asia) L.L.C.
This material has been communicated in the United Kingdom by Goldman Sachs Asset
Management International which is authorized and regulated by the Financial Services
Authority (FSA). This material has been issued or approved for use in or from Singapore by
Goldman Sachs (Singapore) Pte. (Company Number: 198602165W).
This material is provided for educational purposes only and should not be construed as
investment advice or an offer or solicitation to buy or sell securities.
Views and opinions expressed are for informational purposes only and do not constitute a
recommendation by GSAM to buy, sell, or hold any security. Views and opinions are current
as of the date of this presentation and may be subject to change, they should not be
construed as investment advice.
No part of this material may, without GSAM’s prior written consent, be (i) copied,
photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is
not an employee, officer, director, or authorized agent of the recipient.
Simulated results are hypothetical and may not take into account material economic and
market factors that would impact the adviser’s decision-making. Simulated results are
achieved by retroactively applying a model with the benefit of hindsight. The results reflect
the reinvestment of dividends and other earnings, but do not reflect fees, transaction costs,
and other expenses, which would reduce returns. Actual results will vary.
Copyright © 2010, Goldman, Sachs & Co. All Rights Reserved.
30043.OTHER.TMPL / USIILBREF / 01-10