Holden & Partners Quarterly Investment Views: Q2 2019 Outlook

With all inflation-linked securities, value is determined based on ‘breakeven’ inflation rates: the spread (difference) between the yield on an inflation-linked bond and that on an ordinary fixed rate bond. This difference represents an expectation of future inflation rates which is ‘priced-in’ to the market; the higher the differential, the higher future inflation is expected to be. In such an environment, assets aiming to provide returns above the rate of inflation can protect, and increase, investors’ future purchasing power and therefore constitute valuable additions to a diversified portfolio.

Index-linked bonds tend to outperform when market inflation expectations (as suggested by the breakeven inflation rate) are too low, and the actual inflation rate over the life of the bond is higher than the breakeven rate. The ideal environment for these assets is therefore one in which inflation forecasts rise unexpectedly, but interest rates remain relatively low due to economic fragility. Such an environment manifested itself in the UK in the latter half of 2016 in the aftermath of the Brexit referendum, as fears grew that the withdrawal from the EU would result in stagflation (high inflation and low growth).

Higher interest rates can result in a fall in the capital value of fixed income assets, regardless of their inflation protection characteristics, so this should be borne in mind when selecting exposure to the asset class. In the current environment, investors should generally favour short-dated index-linked bonds which are less sensitive to interest rate risk and therefore less susceptible to capital losses.

At present, global index-linked government bonds tend to offer better value than those in the UK. This is because a sustained increase in inflation is likely to be driven by an acceleration in wage growth and this seems more imminent in the US due to the tightness of the labour market. Inflation expectations have increased to reflect this thinking, but there is still the possibility for upward increases in the US inflation outlook. It coincides with a period when relatively soft economic data and pauses in the Federal Reserve’s rate-hiking programme are likely to keep interest rates contained, therefore presenting an environment in which inflation-linked sovereign debt could outperform. The managers of the Aberdeen Standard Global Index Linked Bond fund, which the H&P investment team use, have conviction in this view and hold a large position in US TIPS (Treasury Inflation-Protected Securities) accordingly.

Nonetheless, there are some opportunities within the asset class in the UK due to the uncertainty surrounding the EU Withdrawal Agreement. Although an extension to the Brexit deadline meant that the UK avoided leaving the EU without a deal at the end of March, and both the main parties state that they are committed resolving the current stalemate, there is no guarantee that a compromise will be found before November. A ‘hard’ Brexit would likely result in an inflationary environment in which index-linked bonds would thrive, so we continue to advocate holding a position in inflation-linked gilts to protect against this risk and dampen news-related volatility. High quality inflation-linked corporate bonds, such as those owned by the M&G UK Inflation Linked Corporate Bond fund, provide superior yields to their government equivalents (in order to compensate investors for taking on a small degree of credit risk) and therefore provide an attractive risk-reward profile, particularly in the event of further Brexit instability.

To summarise, inflation-linked bonds are included within a portfolio to:

Maintain inflation protection:

  • Inflation-linked bonds complement other fixed income securities by offering protection against inflation risk (which erodes purchasing power).
  • The prices of inflation-linked bonds respond to changes in real interest rates, instead of nominal rates, thereby providing protection against unexpected inflation as their coupon and principal value adjust accordingly.
  • The IL bond market is a high quality, liquid asset class.

Provide diversification:

  • The positive, but low, correlation of inflation-linked bonds compared to nominal bonds can be a diversifier in portfolios. The periods of lowest correlation often coincide with times of economic uncertainty and market stress, when diversification is of most use value.
  • Traditional asset classes such as stocks and bonds can be adversely affected by periods of persistent inflation, as their cashflows do not increase in line with prices. Inflation-linked bonds, with their explicit link to changes in the inflation rate, are an effective way to achieve real returns without substantially increasing risk.

Content of the articles featured in this publication is for your general information and use only and is not intended to address your particular requirements. They should not be relied upon in their entirety and shall not be deemed to be, or constitute, advice. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No individual or company should act upon such information without receiving appropriate professional advice after a thorough examination of their particular situation. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of any articles. Thresholds, percentage rates and tax legislation may change in subsequent finance acts.


 

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