Bond managers are hastily moving to protect portfolios from an uptick in inflation.
The move could be seen as counter-intuitive, given the UK registered its first negative consumer prices index reading since 1960 last week and inflation in the eurozone recovered to zero only last month.
But expectations are growing that inflation could return at a higher and faster rate than many expect, with even Bank of England governor Mark Carney predicting a 1 per cent rate by the end of this year.
Strategic bond managers said they had either been buying up inflation-linked bonds or increasing exposure to shorter-dated debt, which is less impacted by rising inflation and the interest rate rises that tend to follow it. Both of these can erode returns from bonds, because the level of income the securities pay is fixed.
Nick Hayes, manager of the $450m (£287.6m) Axa WF Global Strategic Bonds fund, said a rise in inflation might not be “aggressive”. But to mitigate any impact on his fund, he has ramped up exposure to inflation-linked bonds, from Europe and the US, from 5 per cent of his portfolio to 12 per cent.
Inflation-linked government bonds now represent half of all the government bond exposure in Mr Hayes’ fund and he has reduced the overall duration on the fund to 3.5 years.
The duration on a bond fund represents its exposure to the corrosive effects of inflation and rising interest rates. The higher the duration, the more exposure a fund has.
Mr Hayes said he had already benefited from the call as inflation expectations had risen, particularly in Europe, in the past couple of months.
Artemis’s James Foster has also moved to protect his portfolio against higher inflation, though he hasn’t used inflation-linked bonds because he thinks they are a “pretty poor hedge” against inflation.
The manager has reduced the duration on his £835m Artemis Strategic Bond fund.
Mr Foster said inflation pressures were “perhaps greater than people had otherwise thought”, due to the recent rise in the oil price and signs of wage price inflation. “Inflation as a story will be more of an issue over the next year,” he said. “I believe yields should be rising to reflect the higher inflationary environment.”
Ian Spreadbury, manager of the £1.6bn Fidelity Strategic Bond fund, said inflation-linked bonds played “an important role” in the fund as a “decent hedge” against inflation. “I feel it makes sense to maintain an exposure of between 5-10 per cent,” he added.
However, Roger Webb, co-manager of the £125m Aberdeen Strategic Bond fund, said investors may be over-estimating the extent to which inflation will rise, predicting a 0.5 per cent level by year-end.
He expected further oil price weakness, the price war in UK supermarkets and the disinflationary forces from competitive currency devaluations to weigh on inflation for some time.
The multi-manager view of inflation
The moves by bond managers to mitigate against the impact of rising inflation points to a growing belief in its imminent return.
Invesco Perpetual’s UK Aggressive manager Martin Walker also said last week he thought many – including the Bank of England – were underestimating the speed and level at which it would return.
But Coram Asset Management’s investment director, multi-manager James Sullivan, said while being in deflation puts the risk/return prospects “back in favour” of inflation-linked bonds, there was “little to excite me about inflationary prospects”. He cited weak earnings growth and a large output gap as major deflationary forces and warned that investors buying inflation-linked debt needed to be sure the issuer - government or business - could handle the rising cost of servicing the debt if inflation does return.
