Managers seek inflation linked bonds as possible hedge
Continued QE policies threaten to stoke inflation, and this is driving interest in inflation-linked bonds among a number of managers.
As inflation concerns loom, some of the largest fund providers are questioning the safety of investing in fixed income. In inflationary conditions, the coupons on all bonds drop in value, unless they are directly linked to inflation.
Even the managing director of the largest fixed income house in the world, Pimco’s Bill Gross, is pessimistic about the outlook for bonds in light of current events in the US.
He says: “If we continue to close our eyes to the fiscal gap in the US, the inevitable results will be that our debt/GDP ratio will continue to rise, the Fed would print money to pay for the deficiency, inflation would follow and the dollar would inevitably decline.”
The only bonds that can withstand this inflationary pressure are inflation linkers. Investing in these can protect the portfolio against significant losses, especially when inflation is accompanied by low economic growth.
Performance of real assets
Jonathan Gibbs (pictured), investment director for fixed interest at Standard Life Investments (SLI), explains there are two different types of inflation, depending on the global growth environment that accompanies it.
If inflation is coupled with a period of robust growth, the best performers tend to be real assets, because better economic conditions boost the demand pool and pricing power of an economy. However, if inflation occurs in a downturn, real assets do not do so well. In this situation, inflation-linked bonds are the only “true” hedge. Such bonds also offer significant diversification benefits, regardless of the inflationary environment and correlation with gilts and corporate bonds is relatively low.
More important, though, is the low correlation with all other asset classes. Interestingly, the correlation between global index-linked bonds and property, a real asset often used as an inflation hedge, is -0.25, lower than any other asset class.
However, ‘inflation-linkers’ have their own issues. For one thing, their duration tends to be long. This exposes the investor to volatility over the inflationary cycle due to shifts in real yields. But over the long term, the vehicle still offers protection, if investors can take on the extra volatility.
Linkers have also been widely criticised for being relatively pricey for the meagre yields they deliver. Gibbs thinks the risk premium of inflation is “not priced in”, so the investor is not rewarded for taking on extra risk. Finally, the asset class is not renowned for high returns.
So far this year, inflation-linked bond funds have been beating inflation, but not by much. SLI’s retail fund, for example, has made 3.3% year to date, while the Barclays global index-linked benchmark hedged to US dollar is up by 4.4% since the start of the year. Inflation in Europe, in comparison, has been about 2.5% all year.
So inflation-linked bonds are no panacea, but they are a useful addition to a balanced investment portfolio. Only this balanced mix of assets can offer protection in all inflationary environments.
The alternatives to inflation-linked bonds are real assets such as real estate, gold and commodities, which tend to offer better returns when inflation is coupled with growth in demand and spending power.
Justin Simler, head of multi-asset product management at Schroders, advocates a dynamic approach suited to the different stages of an inflationary cycle. He says: “Inflation rots your money. You need to be active in terms of shifting between different asset pools to protect your money as the inflationary cycle progresses.”
Many asset managers across Europe are offering portfolios that combine bonds and real assets. Examples are the inflation response multi-asset strategy introduced by Pimco last year and the Barclays European real return fund, which follows a dynamic allocation strategy.
But it would be prudent for investors to examine the holdings of such a portfolio before committing capital, since a mix of assets that performs well in one scenario may suffer losses if the tables turn.
Simler warns that inflation-focused funds are often built around equities or bonds. But for a true inflation hedge, investors must look for dynamic allocation strategies, which allocate to a broader range of different asset classes and can easily shift focus as the global environment changes.