Fixed Income June 2017  

How to protect against rising inflation

This article is part of
How to build a robust yield into a portfolio

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: