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Inflation-Linked Bonds Primer

October 2009
Inflation-linked bonds (ILBs) are a macroeconomic product whose value and cash flows are determined by the rate of growth and consumer price inflation in a particular economy. Therefore, they can offer insight on market expectations of real economies and inflation, which in turn can provide valuable information for investors across all asset classes. Using ILBs, active managers can take different macroeconomic outcomes into account in bond valuation models with the aim of producing substantial risk-adjusted returns above the benchmark. This Special Report is designed to help BlackRock clients better understand the ILB market, the dynamics that drive valuations, and how active managers seek to produce superior risk-adjusted returns.

About BlackRock
BlackRock is a premier provider of global investment management, risk management, and advisory services. As of 30 June 2009, the firm manages US$1.37 trillion across equity, fixed income, real estate, liquidity, and alternative strategies. Clients include corporate, public, and union pension plans, insurance companies, mutual funds, endowments, foundations, charities, corporations, official institutions, and individuals worldwide. Through BlackRock Solutions, the firm offers risk management and advisory services that combine capital markets expertise with proprietarily-developed systems and technology. BlackRock Solutions provides risk management and enterprise investment services for US$7 trillion in assets. BlackRock serves clients in North and South America, Europe, Asia, Australia, Africa, and the Middle East. Headquartered in New York, the firm maintains offices in 21 countries around the world.

Background
Since the UK launched the first sovereign inflation-linked bond in 1981, the global ILB market has grown significantly in both depth and size. The US, France, Germany, Italy, and Japan are all now major ILB issuers. Additionally, countries as diverse as Greece, Sweden, and Australia also issue linkers. As a result, the market capitalization of the global ILB universe has grown from under US$100 million in 1997 to over US$1.4 trillion today.1 The benefits of ILBs are widely appreciated by investors: as an additional fixed-income diversification tool, they most importantly serve as an effective hedge against an acceleration in inflation and provide a means to better match the duration of assets and liabilities.2 However, many investors are not familiar with mechanics, basic valuations, and long-only portfolio management strategies of this asset class.

Inflation-Linked Bond Mechanics

A traditional government bond (nominal bond) pays an investor a fixed amount of interest semi-annually on a principal investment and redeems that principal at maturity. For example, if an investor buys a 10-year government bond at issuance (par) with a principal of US$1,000 and a coupon of 4%, he or she will receive US$20 twice annually for ten years until the bond matures, at which time he or she will also receive the face of US$1,000. The investors return on this investment is 4%. However, prices of goods and services generally rise over time and thus, the real yield, or return after accounting for inflation, will most surely be less than 4%. In this sense, the biggest risk that an investor in a nominal bond faces is the risk that inflation will be higher than anticipated. An ILB protects an investor from the risk of higher-than-expected inflation. Like a nominal bond, an ILB pays an investor a semi-annual coupon on a principal investment.3 Unlike a nominal bond, however, the principal of an ILB grows (falls) over time by the amount of the rise (fall) of inflation. Inflation in this context is typically measured by a domestic consumer price index (CPI), and the level of that index provides the mechanism for adjusting an ILBs principal for inflation. When an ILB is issued, it is assigned a base CPI value, which is simply equal to the level of the CPI on the date of issuance. The inflation-adjusted principal of any particular bond for any given day is therefore easily calculated by multiplying its principal by the ratio of the CPI for a particular trading day over its base CPI value (known as the index ratio).

1 2

According to the Barclays Capital Global Inflation Linked Bond Index as of 31 August 2009. The concomitant development of the inflation derivatives market falls outside the scope of this special report. 3 France, Sweden, Greece, and Germany issue ILBs that pay coupons annually.

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If, for example, the CPI is 100 on the day a particular bond is issued, and stands at 103 one year later, the inflation-adjusted principal of the bond is equal to the principal multiplied by 103/100. This example, seen in Figure 1, implies that the CPI has risen 3% over the course of the year, and therefore the principal of the ILB increases by the same percentage. Regular coupons will be paid on the inflation-adjusted principal on coupon dates, and the inflation-adjusted principal will be redeemed at maturity. These mechanics imply that the cash flows and the inflation-adjusted principal at maturity of an ILB are unknown and will be determined by the path of inflation over the life of the bond. Figure 1: Hypothetical One-Year CPI Track
105 104 103 Index level 102 101 100 99 98 Jul Dec Feb Oct Jan Jun May Aug Nov Mar Sep Jan Apr Date of issue CPI = 100

For example, if a bull market in commodity prices lasts five years before breaking, then five-year ILBs issued at the beginning of the bull market and ILBs of shorter maturities will benefit the most because they will have already matured when the market breaks, commodity prices fall, and the CPI and the value of ILBs are affected accordingly. This dynamic brings cyclicality to the breakeven inflation curve. When the economy is strong, unemployment is falling, and scarcity is accelerating price increases, the breakeven curve becomes flat as shortmaturity breakevens widen relative to long-maturity breakevens to anticipate an increase in cyclical pressures. Conversely, when the economy is weakening, the breakeven curve steepens as short-maturity breakevens narrow relative to long-maturity breakevens in anticipation of a deceleration in cyclical inflation. Figure 2: Anticipated Global Inflation as of 3 September 2009
4.0 3.0

issuance CPI = 103

Inflation (%)

One year after

2.0 1.0 0.0 -1.0 -2.0 2010 2013 2016 2019 2022 2025 2028 2031 2034 2037 2040 2043 2046 2049 2052 2055

Hypotetical CPI index level

Source: BlackRock

Nominal Yields, Real Yields, and Inflation Expectations

Rational investors in nominal bonds anticipate that inflation over the life of a bond will typically be positive and thus, its real yield will be less than the nominal yield (Figure 2). This relationship can be formalized as nominal yield = real yield + expected inflation and is the formula that provides the basis for valuing ILBs relative to nominal bonds. In the marketplace, the difference between nominal and real yields of similar maturities is known as breakeven inflation. Breakeven inflation is the terminology used by the market for expected inflation and can be thought of as the amount of annualized inflation that the market currently expects over the life of the bond. It can also be thought of as the amount of annualized inflation required for an investor to break even when purchasing an ILB instead of a nominal bond. Intuitively, if actual annualized inflation is greater (less) than the breakeven inflation at the time of ILB purchase, then the ILB would return more (less) than a nominal bond. The forces that shape inflation are, not surprisingly, also the forces that shape breakeven inflation. Therefore, cyclical inflation, long-term inflation expectations, and transitory relative-price shifts, particularly in commodity prices, play an integral role in shaping breakeven inflation. Over a long period of time, realized inflation typically converges to long-term inflation expectations. This result partly reflects that transitory relativeprice shifts are, by definition, temporary and thus, typically average out to zero over a long period of time. The implication for long-maturity breakevens is that they tend to reflect longterm inflation expectations and are relatively stable. Over shorter periods of time, transitory price movements and cyclical inflationary pressures play a disproportionate role in determining the path of inflation and the cash flows of ILBs. Shorter-maturity breakevens are therefore much more responsive to these forces because, given their limited time to maturity, they have less time for pay back from transitory price shifts. 2

United States

Europe

United Kingdom

Japan

Source: BlackRock

In the US, the UK, France, and Italy, there is sufficient ILB issuance at various points along the yield curve to compare nominal and real yields of like maturities. By doing this, a full breakeven inflation curve can be derived. Breakeven inflation curves are very useful for relative value purposes. Not only can an investor compare breakeven inflation at various maturities, but he or she can also use the curve to assess the path of inflation that the market expects over time. A two-year breakeven inflation rate of 1.43% implies annualized inflation of 1.43% over those two years, but it does not imply anything about the expected inflation rate in year one or in year two. For example, that two-year breakeven rate could represent steady inflation of 1.43% in both year one and year two, but it could also represent 5% inflation in year one and 2% deflation in year two, or any combination of rates that would make the annualized rate equal to 1.43%. On the following page, Figure 3 illustrates this assertion. To know the expected inflation path with certainty, one would have to also know the one-year breakeven inflation rate. If the one-year breakeven inflation rate were 5% and the two-year breakeven inflation rate were 1.43%, an investor would know that the market expects inflation of 5% in year one and 2% deflation in year two as it is those rates of annual inflation that would produce 1.43% on a twoyear annualized basis. A well-established breakeven inflation curve with breakeven points every year or so along the entire maturity spectrum can tell investors not only the amount of annualized inflation the market expects over a time horizon, but also the path the market expects inflation will take to realize a particular breakeven inflation rate. Using multiple breakeven inflation rates for discerning the expected path of inflation is commonly known as looking at the forward breakeven inflation curve.

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Figure 3: Two Inflation Scenarios

106 105 104 CPI index level 103 102 101 100 99 98 97 Possible CPI Index Today's CPI Index Level = 100 Years from 0 Possible inflation path one Level after one year = 101.439 1 2 Possible inflation path two +1.43% Terminal CPI Index Level Implied by a 2yr breakeven of 1.43% = 102.9 +1.43%

Possible CPI Index Level after one year = 105 +5.0 -2.0%

The nature of real rates and the forces that drive them mean that their levels and curve shapes vary from country to country, as shown in Figure 4. Flexible labor markets and a relatively high rate of labor force growth combine to make potential growth near 2.5% in the US one of the highest rates in the developed world. In the UK and Continental Europe, potential growth is closer to 2.25% and 2% respectively. And in Japan, the aging population and labor force mean that potential growth is perhaps as low as 1.5%. The shapes of real yield curves, meanwhile, can be completely different across countries at any point in time as central banks set overnight rates in accordance with domestic economic conditions.

Source: BlackRock

Strategies for Managing Long-Only ILB Portfolios

Benchmarked

As the vast majority of ILBs are sovereign in nature, credit risk is generally assumed to be sufficiently small to be ignored.4 This assumption implies that real rates on ILBs are representative of risk-free real rates of return. Over a long period of time, basic economic theory suggests that risk-free real rates should be equal to the real return on capital. The real return on capital, in turn, is equal to an economys potential rate of growth. Potential growth rates across economies are not equal because they are predominately tempered by the growth of the labor force and the growth of labor force productivity. Over a shorter time horizon, however, real rates are cyclical and largely determined by a central bank's target rate for overnight money. Of course, this dynamic gives the shape of the real interest rate curve cyclicality as well. When the economy is strong and the unemployment rate is falling, the central bank raises short rates in its best efforts to mute cyclical inflationary pressures and thus, the real curve generally takes on a flat shape. When times are tough and the unemployment rate is rising, the central bank cuts short rates to stimulate demand which, all else equal, steepens the real rate curve. Figure 4: Global Real Rate Curves as of 3 September 2009
3.0 2.5 2.0 Real yield (%) 1.5 1.0 0.5 0.0 -0.5 -1.0 2010 2013 2016 2019 2022 2025 2028 2031 2034 2037 2040 2043 2046 2049 2052 2055

When managing an ILB portfolio, there are several strategies that can be used to produce superior returns relative to the benchmark. ILBs have a large interest rate component and their value is subject to the normal interest rate risk of which all investors must be cognizant. Returns, therefore, can be biased heavily by taking duration risk relative to the benchmark. While duration is a necessary and powerful tool to enhance returns, there are more efficient strategies to employ for producing riskadjusted returns that are often duration neutral.

Probability-Weighted Arbitrage, the Real Curve, and Breakeven Inflation

Probability-weighted arbitrage is especially useful for trading the real curve and breakeven inflation. As discussed previously, nominal rates contain both a real interest rate and inflation expectations component. One can speculate the degree to which a nominal rate is comprised of those components at any point in time by looking at various macroeconomic factors, but one cannot know with certainty how the market weights each factor. ILBs on the other hand provide the markets assessment of both variables via their pricing of real rates and breakeven inflation. They also provide an ILB manager with the opportunity to assess the probability of the markets pricing of, for example, the path of inflation and position a portfolio accordingly. Success with this strategy requires a strong understanding of a central banks reaction function and the likely path of inflation versus the markets expectation of the path. The experience of the US market in the second half of 2008 provides useful examples of how probability-weighted arbitrage can be employed to boost returns. At the beginning of July 2008, the US real curve was steeper than it had been in years. Two-year TIPS provided a slightly negative real yield, while the 5s/10s and 10s/20s spreads were about 80 bps and 60 bps respectively. In reaction to the rising unemployment rate and signs that the economy was in a recession, the Federal Open Market Committee (FOMC) cut the funds rate by 325 bps to 2%.

United States

Europe

United Kingdom

Japan

Source: BlackRock

This assumption is only useful in providing a framework for thinking about what drives long-term real rates. In practice, this assumption is not practical and there are many other factors that affect the value of real rates, most notably sovereign risk.

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With a view that the recession would intensify and underlying inflation would slow as cyclical inflationary pressures eased, there was a high probability that the FOMC would, at the very least, keep the funds rate at 2% for a long time, and a reasonable probability that it would have to cut the funds rate further. All else equal, that would mean that the real curve should be steep for the foreseeable future. But all else was not equal! Figure 5: The US Spot Breakeven Curve as of 3 July 2008
3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032

Because inflation markets were arguably priced for a further rise in commodity prices, the biggest risk in our view was that commodity prices would stabilize or correct and the inflation priced into the market would not be realized. Such a correction would flatten out the very steep real curve. The prudent course of action was to position the portfolios defensively by selling shorter-maturity ILBs and buying a duration-weighted amount of long-maturity ILBs. Qualitatively this trade can be thought of as a way of expressing the view that the path of inflation priced into the front part of the inflation curve was not likely to be realized. Commodity markets, of course, did correct in the second half of 2008 and the real curve flattened markedly as investors recognized that the amount of inflation priced into the shorter-maturity ILBs would not be realized. Structuring a portfolio to benefit from curve flattening is not the only way to protect capital in such a scenario. Breakeven inflation, as mentioned before, was priced very high given the circumstances, and the probability of those breakeven rates being realized was low. If there were ever a time when having too much inflation protection was a bad thing, it was most certainly in July 2008. The prudent course of action was to sell shorter-maturity ILBs and buy nominal bonds. If the most likely scenarios were to be realized that is, the FOMC keeping overnight rates low for a long time and realized inflation being well short of the inflation expected by ILBs then nominal rates would markedly outperform ILBs as inflation expectations fell and breakeven inflation narrowed. Figure 7: The US Spot Breakeven Curve as of 2 January 2009
2.0 1.0 0.0 -1.0 Spot (%) -2.0 -3.0 -4.0

Source: BlackRock

Figure 6: The US One-Year Forward Breakeven Inflation Curve as of 3 July 2008

3.5% 3.0% 2.5% Inflation (%) 2.0% 1.5% 1.0% 0.5%

Spot (%)

-5.0

0.0% 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032
-6.0 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032

Source: BlackRock

Source: BlackRock

Part of the reason for the steepness in the real curve was the run up in energy and commodity prices in the first half of 2008 and the associated rise in the CPI. As those prices climbed, the breakeven curve rose and flattened, and by the beginning of July, the real curve stood between 2.75% and 2.50% out the entire maturity spectrum (Figure 5). The forward breakeven curve indicated that the market expected nearly 2.75% inflation in each of the next five years and about 2.50% inflation thereafter (Figure 6). Normally that pricing scenario would be plausible. However, it would require energy prices which made up approximately 10% of the CPI to at the very least stabilize and more reasonably, rise by a modest amount in each year. Crude oil prices had risen 50% since the beginning of 2008 and were trading over US$140 per barrel an all time high both in real and nominal terms. Given that the economy was entering a severe recession, the probability that energy prices would stabilize at all-time highs seemed rather low. 4

By the end of the fourth quarter 2008, 10-year breakeven inflation was zero percent and every breakeven inflation rate with a maturity shorter than 10 years was negative, which is shown in Figure 7. Of course, the astute investor would know that the market was not pricing in 10 years of deflation by looking at the forward breakeven curve. Instead, he or she would see that the market was priced for nearly 4% deflation in 2009, 2% deflation in 2010, and low but positive inflation thereafter; Figure 8 illustrates this statement. The real curve, meanwhile, was near all-time flat levels.

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The risk had once again shifted. Unless energy prices fell significantly further from US$35 per barrel, 4% deflation would simply not be possible given the stickiness of underlying inflation. And given the efforts of the central banks to stimulate demand, the risk was certainly high that the real curve would steepen. The greatest risk/reward, therefore, was buying the mispriced shortest-maturity ILBs and structuring portfolios for real yield curve steepening. Figure 8: The US One-Year Forward Breakeven Inflation Curve as of 2 January 2009
4.0% 3.0%

The lower quality credits, specifically Greece and Italy, trade poorly during flight-to-quality allocations, and typically trade better once fears subside (Figure 9). And as a general rule, they should trade at some concession to France and Germany. The advantage of having a diverse range of credits in the Global ILB Index is that it gives a sovereign index a credit component it would not otherwise have, and thus an additional tool for active managers. Figure 9: Yield Spread Between ILBs Issued by France and Italy
160 140

2.0%

120
Inflation (%) 1.0% 0.0% -1.0% -2.0% -3.0% -4.0% 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032

Basis points

100 80 60 40 20 0 Jul-07 Jul-08 Jan-08 Jan-09 Jul-09

Source: BlackRock

Source: BlackRock; data as of 5 October 2009

Cross-Country Strategies
Global ILB portfolios provide the additional dimension of crosscountry allocation. Here the majority of opportunity is in real rates, but breakeven inflation can be a source of opportunity as well. For example, a view of the relative responsiveness of central banks to evolving domestic economic conditions can, at times, provide opportunities to buy shorter-maturity ILBs in one country versus those of another country. But positions in shorter real rates, as we know, can be violently affected by changes in inflation expectations. Therefore, successful trades of this kind require compelling arguments, high conviction levels, and at times, hedges in nominal rates. Cross-country trades in longermaturity real rates are less noisy because they are not as responsive to changes in commodity prices and thus, short-term inflation expectations. As mentioned earlier, the fair value of longer real rates is determined by the speed limits of long-term growth. Knowing these limits stand near 2.50%, 2.25%, 2.00% and 1.50% for the US, the UK, Continental Europe, and Japan, respectively, certainly does not tell one how to structure a portfolio. However, it does provide a framework for active management. If, for example, long European real rates were trading at 2.50% and those of the US were near 1.75%, there would certainly be reason to question relative valuation. Over some time horizon, it is likely that those spreads will converge closer to their long-term values, perhaps providing opportunity for a cross-country allocation. Europe deserves a special mention in this regard. The Continental European ILB market is composed of four issuers: France, Germany, Greece, and Italy. France and Italy are the most prolific issuers, while Germany and Greece currently have three and two issues outstanding as of 31 August 2009. The spectrum of issuers introduces uniqueness to the market revolving around the difference in credit ratings; France, Germany, Greece, and Italy have very different borrowing needs and abilities to make good on long-term liabilities. Thus, real rate differentials will also be affected by changes in ability-topay perceptions. 5 The UK has its own quirks that distort the value of its real rates. A number of pension funds are required by law to buy long-term real yields to better match the duration of their assets and liabilities. Unfortunately the demand is so large that there are more buyers than there are bonds and as a consequence the real yield curve in the UK is very low and inverted.5 There are few intelligent ways to take advantage of these non-economic flows, other than to respect their existence and know that real yields in the UK will trade richly because of them.

Idiosyncratic Factors Specific Relative-value

and

Issue-

While the majority of alpha is generated from real curves, breakeven inflation, and cross-country allocation, idiosyncratic factors can provide alpha opportunities through issue-specific relative-value. A number of issuers, for example, embed a deflation floor in ILBs.6 The deflation floor is an at-maturity concept, and it guarantees that an issuer will pay par value at maturity, even if the current value of the CPI is less than a particular bonds base CPI. For example, if a five-year ILB is issued with a base CPI value of 100 and at maturity the CPI stands at 90, the issuer will treat the index ratio as 1 (100/100) instead of 0.9 (90/100). Because inflation is nearly always positive, the most recently issued ILBs have the highest deflation floors.

5 6

As of 5 October 2009, UKTI 2055 ILBs were trading at 43 bps. As of 5 October 2009, these issuers included the US, France, Italy, Sweden, Germany, Greece, and Australia. The UK, Japan, and Canada issue ILBs without deflation floors.

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In a deflation scare, the deflation floors of the newest ILBs are the closest to being in the money. Therefore, they have the least amount of accrued inflation to lose and can acquire a huge amount of value relative to older ILBs. The value of the deflation floor is normally very close to zero, but when deflation risk is priced into the market the value of the floor can be enormous, as seen in Figure 10. Floors can be valued using Monte Carlo-type simulations during times where deflation risk is deemed quite high, and those estimated values can then be used to assess whether or not the market is properly valuing them. Figure 10: Spread between Old and New Five-Year ILBs
250

There are other idiosyncratic issues in the various ILB markets that can affect an individual bonds value, but addressing all of them is certainly beyond the scope of this primer. The major issues have been addressed herein. As discussed, the cash flows of linkers are not fixed and ultimately will be determined by the amount of inflation that occurs over the life of a linker. Mathematical tools can help managers discern the implied path of inflation over time in various markets, and when combined with an understanding of what drives inflation and inflation expectations, managers can judge whether actual inflation will be sufficient to realize the cash flows priced into the market. Of course, ILB managers must also consider the forces that determine the shape of the real yield curve, which are predominantly central bank reaction functions and structural drivers of real economic growth. With a sound understanding of these factors, active managers can take advantage of the opportunities presented by global ILBs to generate significant risk-adjusted returns.
For additional information, please see the Glossary of Key Terms on the next page.

200

150 Inflation (%)

100

50

-50 Apr-08 Aug-08 Apr-09 Aug-09 Dec-08

Source: BlackRock; data as of 5 October 2009

The UK market features two different models of outstanding ILBs. The oldest ILBs are unique in that they accrue the inflation that occurred eights months prior.7 In 2005, the UK began issuing ILBs that accrue inflation with a three-month look back, which is consistent with how the vast majority of ILBs accrue inflation. The older ILBs have therefore become illiquid and most active trading is now done in the newest issues. The exception to the illiquidity is during months of issuance; as the composition of the index changes to include fewer old ILBs and more new ILBs, index funds must sell the older ILBs. Liquidity in the older issues therefore improves in these time periods and provides a window of opportunity to reposition in these bonds. The French market also features two different models of outstanding ILBs with both models currently being issued. The difference in the models is the inflation index used to accrue inflation; the OATei bonds accrue euro-zone inflation while the OATi accrue French inflation. The differences in the indices are minimal and include, but are not limited to, slightly different weights on various sub-components (including lower food and energy weights on the French index). The bottom line is the seasonality profile of the French index varies from that of the Europe index, and that difference in profile can affect the relative value of the bonds. There are times when the market does not appreciate these subtle differences and active managers can take advantage of this mispricing accordingly.

Most issuers have designed ILBs using what is known as the Canadian Model, in which inflation is accrued with a three-month lag. The intuition behind the model is that a three-month lag always provides enough known monthly inflation readings to calculate the current index ratio.

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Glossary of Key Terms

Base CPI value: The level of the CPI index on the date a particular ILB is issued, which provides the basis for adjusting its principal for inflation (deflation) that occurs over its life. Breakeven inflation: The difference between the yield of a nominal bond and an ILB of like maturity. It represents the amount of annualized inflation expected over the life of a bond by the marketplace, but it can also be thought of as the amount of annualized inflation required for being indifferent to holding the nominal or the ILB. If actual inflation turns out to be higher (lower) than the breakeven rate, the ILB will have a higher (lower) return than a nominal of like maturity. Breakeven inflation curve: The difference between nominal and real yields of like maturities at every available point along the yield curve. Central bank reaction function: The response (in terms of changes in its overnight interest rate target) of a given central bank to deviations in growth/employment and inflation around some implicit or explicit targets. Typically when growth is above (below) its trend rate and inflation is accelerating (decelerating), the central bank is raising its overnight target to prevent overheating (a recession) and higher (lower) inflation. Consumer price index (CPI): A basket of goods and services with weights usually determined by survey or expenditure share, which measures the cost of living for the average consumer. The domestic CPI is usually a measure of inflation to which the principal of an ILB is linked. Cyclical inflation: A change in the rate of inflation caused by scarcity or excess capacity. When an economy is growing quickly and unemployment is falling, typically this force encourages firms to raise prices faster. Conversely, when the economy is weak and unemployment is rising, this force would, at the very least, cause firms to raise prices by less than they otherwise would and at times actually exert downward pressure on prices. Deflation: A decline in the overall price level of an economy. Deflation floor: Principal protection that some issuers include in their ILBs, which is equal to an ILBs base CPI value. An atmaturity concept, deflation floors guarantee a creditor that if the CPI level is below a particular bonds base CPI value at maturity, the CPI level used to calculate the inflation-adjusted principal will be equal to the base CPI value. In other words, the index ratio will be 1 and the creditor will receive back par even though the true inflation-adjusted principal would be below par. Forward breakeven: The rate of inflation required to equate two points on the breakeven curve. In other words, a forward breakeven calculated from a 5-year and 10-year breakeven is the mathematical amount of annualized inflation implied to occur beginning 5 years from today and ending 10 years from today, given the 5-year and 10-year breakeven. Forward breakeven inflation curve: A series of forward rates extrapolated from the breakeven inflation curve that reveals the markets expectation for the path of inflation.

Index ratio: Ratio of current CPI index level to the base CPI index value of a particular bond. If the CPI index level rose to 120 today from 100 at issuance of a particular bond, the index ratio would equal 1.2. The index ratio multiplied by the principal of a bond equals the inflation-adjusted principal. Inflation: A rise in the overall price level of an economy. Inflation-adjusted principal: The principal of an inflationlinked bond after it has been adjusted by the amount of inflation (deflation) that has occurred since the bond was issued. The adjustment occurs by multiplying the index ratio by a bonds principal. Inflation-linked bond (ILB): A bond whose principal is increased (decreased) in proportion to the amount of inflation (deflation) from the date of issue to the date of maturity, and whose coupons are paid on the inflationadjusted principal. At maturity, the inflation-adjusted principal is redeemed. The mechanics of an ILB imply that its cash flows and principal at maturity are unknown and are determined by the path of inflation over its life. Long-term inflation expectations: The rate of increase in the general price level of an economy expected by the general public and investors over a long period of time. It is the most powerful determinant of inflation; once an expected rate is embedded in the mind of investors and the public, it is very hard to change. Nominal bond (or nominal): A bond whose principal and cash flows are fixed. In the context of this primer, refers to only sovereign nominal bonds. Nominal yield: The yield on a bond whose cash flows and principal are fixed (nominal bond). Can be thought of as being composed of two components: an investors expectation for inflation over its life and for its real return (or real yield). Probability-weighted arbitrage: Assigning probabilities to outcomes priced into a market and positioning a portfolio accordingly. Particularly useful when managing a portfolio of ILBs. Real yield: The yield on an inflation-linked bond. Can be thought of as the return of a bond after an investor takes into account the inflation that has occurred over its life, and thus the increase in his or her purchasing power. Real yield curve: ILB yields at every point on the maturity spectrum. Transitory relative-price shift: A one-time shift in the price of one good or service, or group of goods or services, relative to all other goods and services. These shifts can boost (lower) the overall price level if the weight of the good or service and/or the increase (decrease) in its price is sufficiently large. At times, these shifts can also pass through to other goods and services and encourage changes in those prices too. For ILBs, the most important of these include shocks to commodity prices.

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For distribution in EMEA for Professional Investors only, or (professional clients, as such term may apply in relevant jurisdictions). In Japan, not for use with individual investors. This material is being distributed/issued in Canada, Australia and New Zealand by BlackRock Financial Management, Inc. ("BFM"), which is registered as an International Advisor with the Ontario Securities Commission. In addition, BFM is a United States domiciled entity and is exempted under Australian CO 03/1100 from the requirement to hold an Australian Financial Services License and is regulated by the Securities and Exchange Commission under US laws which differ from Australian laws. In Australia this product is only offered to "wholesale" and "professional" investors within the meaning of the Australian Corporations Act). In New Zealand, this presentation is offered to institutional and wholesale clients only. It does not constitute an offer of securities to the public in New Zealand for the purpose of New Zealand securities law. BFM believes that the information in this document is correct at the time of compilation, but no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BFM, its officers, employees or agents. This document contains general information only and is not intended to be relied upon as a forecast, research, investment advice, or a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information does not take into account your financial circumstances. An assessment should be made as to whether the information is appropriate for you having regard to your objectives, financial situation and needs. The opinions expressed are as of October 2009 and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Any investments named within this material may not necessarily be held in any accounts managed by BlackRock. Reliance upon information in this material is at the sole discretion of the reader. Past performance is no guarantee of future results. 2009 BlackRock, Inc., All Rights Reserved. The actual yield of inflation-linked bonds will fluctuate based on the rate of inflation.

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