Signs of a fund selector exodus from index-linked bonds have begun to emerge as trepidation about the “inherent” duration risk in such products threatens to outweigh their appeal as an inflation hedge.
UK inflation expectations have risen sharply since sterling tumbled last summer, in an apparent end to lingering deflationary fears that was then bolstered by the election of pro-fiscal stimulus US president Donald Trump last November.
The change in sentiment was accompanied by fund selectors and market participants moving into index-linked bonds, which can adjust their coupon payments to help offset inflation. Such assets have enjoyed strong performances as the UK currency has faltered, with the FTSE Actuaries UK Index-Linked All Stocks index rising by 16.8 per cent since the EU referendum.
But in recent months the mood has turned, with a number of fund buyers, including those from Brown Shipley, Lumin Wealth, P1 Investment Management and Tcam, moving away from index-linked exposure.
Figures from the Investment Association released last Friday showed the largest net outflows on record for index-linked gilt funds in January, equivalent to 2 per cent of the sector’s assets.
A key issue has been a fear that while linkers can shield investors against inflation, they are typically long-dated instruments – leaving them exposed if benchmark bond yields rise higher.
Duncan Blyth, investment research director at Tcam, warned that duration was “inherent” in such products, outweighing the benefits of inflation protection.
“While the coupon or capital repayment may be indexed to inflation, the market price of linkers is impacted by rising interest rates, with the expected future cashflows being discounted at a higher rate,” he said.
“Investors will definitely receive a return linked to inflation if the bond is held to maturity, but not necessarily before.”
Some have begun to seek alternative forms of protection against rising prices.
Daniel Lockyer, chief investment officer at Hawksmoor Investment Management, has turned to real estate investment trusts such as the recently launched LXI vehicle, which buys property with leases of 20 to 25 years.
“We are taking credit risk rather than government risk,” he said.
But this change of mood stands in stark contrast to the attitude of some asset managers, who are standing by their index-linked exposure.
The board of the Ruffer Investment Company, which had an 11 per cent allocation to long-dated index-linked instruments at the end of January, has defended this weighting in a recent half-year report.
“Our answer is not to cut back on the investments that could prove to be the only port in a storm in the future (index-linked bonds), but to find ways to protect them in the short term with offsetting investments (cyclical equities and interest rate options),” it said.
Others have highlighted funds run by fixed income teams keeping a wary eye on interest rate risk. Ian Aylward, of Barclays Wealth, has favoured M&G’s UK Inflation Linked Corporate Bond fund, noting the product had a duration of less than one year.
