How to protect against rising inflation

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AXA Investment Managers
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Supported by
AXA Investment Managers
How to protect against rising inflation

What sort of inflation-busting strategies should advisers consider when putting together an income portfolio?

With inflation edging up to 2.7 per cent currently and inferences from the Bank of England that CPI will hit 3 per cent by the end of the year, inflation is becoming a consideration for investors.

It is worth stating at the outset that inflation is nowhere near its heady heights of the 1970s, and generally since 1960 it has hovered around 5 per cent. Moreover, since the Bank of England achieved its independence, it has maintained an average yearly inflation rate of 2.02 per cent – pretty much on its 2 per cent target.

Inflation can have a positive effect on savers, as investors putting money aside in the 1970s and 1980s can testify.

Chris Leyland, deputy chief investment officer for True Potential, explains: “A lot depends on the future level of inflation.

“A rate hovering between 2 per cent and 4 per cent, as a rough rule of thumb, represents a sweet spot.

"Equity investors invested in businesses earning double-digit returns on invested capital should benefit and the ongoing economic healing we are witnessing allows fixed income investors to benefit from narrowing credit spreads."

Shorter maturities on the curve look more attractive to us as interest rate hikes will be far more gradual and less numerous than in earlier economic cycles. Jonathan Baltora

That said, any rise in inflation in this low-interest world is a consideration for investors in terms of spending power in the investor’s pocket. Mr Leyland adds: “Beyond a certain level, inflation is bad for all investors and it is why central banks seek to manage it.”

Therefore, advisers should be looking for ways to mitigate the eroding effect of inflation on the value of portfolios.

Jonathan Baltora, portfolio manager for AXA Investment Managers, says: “Inflation is a concern across bond investors. 

“After years of falling inflation, the normalisation we are currently witnessing is a concern.”

ONS: January 2006 to April 2017 - peaks and troughs in CPI

He gives two reasons for this concern: central banks starting to normalise monetary policies, and the concept of financial repression.

Mr Baltora explains the effect of large-scale asset purchases on long-term interest rates have had the effect of pushing bond yields lower. “On average, 25 per cent of an economy’s GDP in asset purchase equates to 1 per cent lower bond yields, which gives an idea of how big a post-quantitative easing bond yield normalisation could be. No doubt this would be negative for longer-term bond holdings.”

Moreover, he says should the Federal Reserve decide to gradually unwind its balance sheet by not reinvesting the proceeds from maturing bonds, there is a risk that longer maturities would under-perform and the yield curve would steepen.

“In this regard, shorter maturities on the curve look more attractive to us as interest rate hikes will be far more gradual and less numerous than in earlier economic cycles, due to higher indebtedness and lower structural growth,” he says.

Inflation-linked bonds

Inflation-linked bonds are one way to mitigate inflation risk in a fixed-income portfolio. These are primarily issued by sovereign governments, and the bonds are indexed to inflation. This means the principal and interest payments rise and fall at the same time as inflation.

In a financially repressive environment, as outlined earlier by Mr Baltora, safer real rates are pushed in to negative territory – in other words, nominal bond yields are pushed lower than inflation – to stimulate investors’ appetite for riskier and higher-yielding assets.

Mr Baltora comments: “Such a situation can be addressed with investments that will deliver higher than inflation rates of returns. 

“This can be the case with some higher-yielding segments of the bond market, or inflation-linked bonds that have both an income and principal that is fully indexed to inflation.”

Dan Ivascyn and Alfred Murata, managers of the Pimco Income Fund, comment: “We have the flexibility to invest in inflation-linked bonds to explicitly protect the portfolio against an unexpected rise in inflation, but we are not presently using it.”

Fidelity International's Eugene Philalithis agrees inflation-linked bonds can be a “good source of income protection” but adds “these are not attractive from an income perspective”, as yields tend to remain low.

Short-duration strategies

Short-duration strategies are another good way of preventing inflation from eating into long-term fixed income returns.

Keeping a long duration with fixed income investments is sometimes used to meet liabilities but it can be highly risky, depending on interest rates and inflation.

For example, high interest rates and a high duration could have a deleterious effect on the bond fund's performance. Holding a low-yielding bond for long could end up with rises in inflation far outstripping the yield. A tool on AXA Investment Managers' website provides a handy guide to how duration can pose a risk to bond prices.

According to the Pimco managers: “We think the risk of a large near-term inflation surprise in developed markets is low.

“For investors who have a clear view that inflation and rates will rise, we have low duration or duration-hedged products available. 

“However, we have found that, most of the time, duration is a welcome diversifier to most portfolios, especially those with high equity exposure.”

Mr Baltora adds: “From an investment perspective, in the current environment, short-term bonds that by definition have a lower sensitivity to interest rates are an asset of choice.”

In fact, over the past few months as awareness and therefore demand for this strategy has increased, there have been several short-duration fund launches for UK retail investors, including: 

  • May 2017 – AXA Investment Managers launches the AXA Global Short Duration Bond Fund.
  • February 2017 - Candriam launches its GF Short Duration US High Yield Corporate Bonds Fund.
  • January 2017 – Pioneer Investments launches its Optimal Yield Short-Term strategy.
  • October 2016 – SLI launches Short Duration Corporate Bond Fund. Aberdeen and Canada Life also both launched short duration corporate bond funds the same month.
  • October 2016 - Royal London Asset Management launches the Short Duration Gilt Fund, the Royal London Short Duration Credit fund and the Royal London Short Duration Global Index Linked fund.
  • July 2016 – AXA Investment Managers launches the AXA World Funds Global Inflation Short Duration Bonds Fund.

According to Mr Baltora, the impact of inflation-led monetary policy normalisation and financial repression makes the situation “already complex” for investors, even without any acceleration of the current inflation regime.

Therefore, it is understandable why some advisers have been drawn to short-duration bonds for appropriate clients.

He adds: “Investors may look for pockets of value in short-duration bonds offering a higher-than-inflation-income, or inflation-linked bonds with a short duration as, on top of a lower duration, their performance has historically been more closely correlated with realised inflation.”

Patrick Connolly, head of communications for Chase de Vere, agrees that short-duration bonds can provide a greater degree of capital protection, although says this is coupled with a lower yield, which might be a consideration for some clients.

​He adds: “While investors should be concerned with beating inflation in the medium to long-term, this may be more of a challenge in the short-term, as fixed interest yields are quite low and inflation is edging upwards.”

Dan Ivascyn and Alfred Murata, managers of the Pimco Income Fund, caveat that higher rates can also translate into higher returns for bondholders, so if advisers are to cut the duration at the wrong time, this could result in missed opportunities.

Nicholas Wall, manager of the Old Mutual Global Strategic Bond Fund, actually likes long duration – that is, some select long-duration in the form of financials.

He explains: “Banks make profit by buying cheaply from depositors and wholesale markets, and lending at a higher rate.

“Profit margins, therefore, have been squeezed by negative interest rates as banks were reluctant to charge customers for their money, and flat yield curves – reducing their earnings spread.

“An inflationary impulse increasing this spread through positive interest rates and steeper curves would likely see financials outperform the broader market.”

Diversification

For Darius McDermott, managing director of Chelsea Financial Services, having a mixture of different bond exposures and durations will be useful for advisers in creating inflation-proof fixed income strategies for their clients.

He explains: “Higher yield, short duration and inflation linked assets (whether that is bonds or assets like infrastructure) are all options.”

Infrastructure as an alternative source has also been highlighted by Fidelity’s Mr Philalithis, who says: “Infrastructure offers attractive inflation protection, with social infrastructure vehicles often linking their payments to inflation.

“This is not so common with economic infrastructure but they still offer good inflation protection generally."

For example, he says the Fidelity Multi-Asset Income portfolio has a holding in the Sequoia Economic Infrastructure Fund. Approximately 50 per cent of the fund’s debt is in floating rate notes, which brings down the duration of the fund to a low level overall.

“The answer, as with many investment questions, is asset allocation and diversification,” says Mr Connolly.

“Most investors should hold a wide range of different fixed-interest assets which are spread globally, and then combine these with other diversified asset classes, such as property, equities and cash.

“In the current low interest rate environment, it may be this approach will not produce the natural level of income required by the client. However, the right asset allocation approach should not be compromised simply to achieve a higher yield.

The answer, as with many investment questions, is asset allocation and diversification. Patrick Connolly

“We don’t want to make calls between different fixed interest assets, so for many clients we get exposure through investing in a range of strategic bond funds, using funds with experienced managers and teams.”

Ultimately, as Stephen Crewe, director of Fulcrum Asset Management says, a strategy that solely focuses on generated income, without regard to the unintended consequences for portfolio risk will “shock investors at some point in the future”. 

For clients relying on their portfolios to provide even 4 per cent income, especially clients who can ill afford to take too much market risk, such as people approaching or in retirement, it’s not just about chasing income. 

It’s about chasing the right kind of income, from the right mix of assets, for the right duration and the right level of risk.

simoney.kyriakou@ft.com