Inflation-linked bonds: more than just inflation
- 10 July 2024 (3 min read)
With inflation expected to be more uncertain and volatile than in the previous decade, investors may want to consider hedging the inflation risk of their portfolios. Inflation continues to edge towards central bank targets, however with stickiness in services’ sector inflation and some base effects, there could be some bumps along the way to the desired 2% level. This suggests investing in inflation-linked bonds may be an option to mitigate against this sticky inflationary environment.
At the beginning of 2024, we explored why investors may still want to consider inflation linked bonds in a falling inflationary environment1 . Many of the reasons mentioned then still apply now. In particular, the fact that inflation risk remains tilted to the upside. This continues to be a focus with the upcoming elections creating uncertainty over whether governments will be able to reduce public deficits or if it could lead to increased borrowing. Along with political uncertainty, geopolitical tensions and climate change concerns are other aspects that may slow the disinflationary march. We think it is therefore still relevant to consider inflation-linked bonds within a portfolio.
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Breakeven performance signals the outperformance (or underperformance) of inflation-linked bonds relative to a comparable nominal bonds’ universe.
How to make the most of ILBs
At the moment, with real interest rates still in restrictive territory and growth expected to be subdued, long duration positions remain attractive. However, as central banks begin to cut interest rates, the front end and the steepeners positions should begin to look more attractive. This need to adjust duration allocation in order to optimise returns, is seen in the charts above, reflecting how each segment of the curve (front end and long end) have performed in different inflationary environments. We believe this demonstrates that taking an active approach to an investor’s inflation portfolio may be help to achieve better risk-adjusted returns.
The history from the past decade offers evidence that diversification within an inflation-linked bond portfolio may help investments from either credit-related events like the Euro Area crisis in 2011 and 2012 or duration swings such as 2022/2023. Not only should an inflation-linked bond global approach offer a better risk/return profile thanks to its diversification benefits, but we believe that there are broader opportunities available within a global approach than that of a local focus.
A global approach will tend to favour relatively higher real interest rates and, as a consequence, may maximize investors’ income adjusted for inflation. As the chart below shows, real rates remain in positive territory. We do not, therefore, expect them to subtract income to the asset class, unlike the past 10 years.
Likewise, a flexible active strategy may also bring value to the table by leveraging on seasonal inflation swings. A flexible approach should be able to allocate assets where inflation accruals are the sharpest and potentially benefit from seasonal patterns or structurally higher inflation.
Although we face a disinflationary environment, inflation risks remain tilted to the upside, so in the medium term, inflation-linked bonds may still have a role in mitigating against this risk. They can also play a broader role in a portfolio, offering investors diversification and low correlation to other investments without necessarily taking on additional credit risk.
Disclaimer
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