From Special Report: Fixed Income Investing - May 2012
Protecting portfolios against above-target inflation
There are a range of instruments that advisers and investors can do to mitigate the deleterious effect of inflation on returns.
In March, UK consumer prices index inflation rose to 3.5 per cent, and Paul Tucker, deputy governor of the Bank of England has warned that it is likely to stay that way for the rest of the year.
This is in spite of the Bank’s previous forecast that the inflation rate would “probably fall to the official 2 per cent target by the end of 2012”.
Notwithstanding projections of a general downward trend over the medium term, investors and advisers should therefore be taking steps to mitigate the impact of this stubbornly high inflation on their portfolio performance.
Russ Koesterich, managing director and chief investment strategist at iShares, argues that fixed income investors face a stark choice between low nominal rates and often negative real rates, or increasing risk to generate incremental yield.
“We would advocate reducing duration risk, for which we believe investors are not being adequately compensated, and modestly increasing exposure to spread products.
“We would advocate looking to US corporate debt, specifically investment grade, high-grade municipals and emerging markets.”
Nick Gartside, CIO of Fixed income at J.P. Morgan Asset Management agrees, adding: “Government yields, close to generational lows, still look unattractive and we expect Treasury yields to bubble higher over the next few months as the eurozone risk premium is unwound and as the market adjusts to the reality of better economic data prints.
“Emerging market debt continues to be one of our top picks as do other spread sectors such as high yield, where both fundamentals and valuations look good.”
However, with real yields substantially lower over the past few years and the UK experiencing persistently above-target inflation, pricing for inflation-linked gilts has become very firm.
At the start of the year, veteran bond investor Jim Leaviss raised exposure to index-linked bonds in his M&G Global Macro Bond fund to a record high level, based on his view that break-even rates – the difference in yield between a nominal and an index-linked bond – are highly attractive.
He says: “Inflation protection is cheap and should be considered by investors who are concerned about future price rises.”
According to Investec Wealth and Investment, the difference between the yields on a 10-year conventional gilt and a 10-year inflation-linked gilt is approximately 2.8 per cent, based on the implied rate of UK inflation over the next 10 years derived from the gilt market.
Given that inflation-linked gilts provide protection from the retail price index rather than CPI and, historically, the difference between the two measures has been around 0.6-0.8 per cent, this suggests that investors are locking into a break-even CPI inflation rate of roughly 2 per cent.
Darren Ruane, senior bond strategist at Investec Wealth and Investment, explains: “Investors generally want to achieve returns greater than inflation over the life of an investment and real returns from inflation-linked gilts are currently negative.
“In addition, at some point, real government bond yields could adjust to rates of maybe 2 per cent to 3 per cent once the economic cycle has normalised.
“However, inflation-linked gilts play an important role as insurance in a diversified portfolio, they provide protection against the potential for higher inflation over the long term and it is unlikely that real yields will rise materially in the short term.”
According to data from FE Analytics, the average fund listed in the IMA UK Index-Linked Gilt sector has returned 52.6 per cent over the past five years, outperforming the CPI as well as the 0.6 per cent return from the average UK All Companies fund.
Long-term inflation drivers
According to Investec, over the longer term there are many reasons to suggest that inflation could be higher than history has witnessed over the past 15 years.
For example, the group claims that in an environment where sovereigns are struggling to pay off debt, high inflation could ease the burden of paying back creditors. Also, inflation is a natural by-product of central banks’ continued policy of weakening currency through quantitative easing.
In February, the European Central Bank’s second long-term refinancing operation saw 800 banks take up a total of €530bn in three-year funding. This followed the injection of €489bn in the first LTRO in December.
Since the introduction of these measures, risk appetite has improved dramatically.
Mr Gartside explains that Italian two-year bond yields had spiked to 7.5 per cent back in November, with concerns mounting over Italy’s ability to refinance its debt. In early March, the same bond was yielding 2 per cent, and Italy is on target with its refinancing over the year to date.
The extraordinary liquidity support is not coming only from the ECB. The Bank of England announced a further £50bn of QE in February, while the Bank of Japan unexpectedly announced Y10trn of additional QE.
The Bank of Japan also introduced a new 1 per cent inflation target after more than two decades of zero inflation/deflation, a commitment that is expected to require yet more asset purchases.
In emerging markets, meanwhile, several central banks have begun to cut rates, and China has reduced the reserve requirement ratio for its banks. In sum, this global trend represents the biggest increase in liquidity since 2009.
Chris Iggo, CIO of fixed income at Axa Investment Managers, says: “ It is without doubt that quantitative easing has delivered lower government bond yields than would have been the case if central banks had not turned to the chapter of their ‘Handbooks of Monetary Policy’ titled, “Unconventional Measures (otherwise known as what to do when all else fails)”.
“Of course, there have been other influences on the level of bond yields over the past year, including the commitment to zero interest rate policies and the safe haven buying of apparently risk-free assets during the worst phase of the European debt crisis.
“However, QE has worked by depressing yields along the curves of the UK gilt, US Treasury and Japanese government bond markets. It must have, surely, as central banks have acquired assets through various programmes to the extent that their balance sheets have grown to the equivalent of 20 per cent to 30 per cent of nominal GDP.”
He adds that in the UK, the Bank of England purchases of gilts mean that it is the owner of around one-third of the outstanding stock of government debt.
“QE has not replaced demand for government bonds, it has added to demand,” Mr Iggo concludes.