Inflation-linked bonds seem like an obvious way to maintain exposure to fixed income while also having some protection from the impact of rising prices on the spending power of the portfolio.
Yet despite that, inflation-linked bond prices have fallen this year to date.
What are inflation-linked bonds?
In simple terms, inflation-linked bonds are only one step more complicated than a standard bond. There is of course a date in which the bond will mature, a cash flow stream (known as the coupon), and a par amount borrowed by the issuer of the bond and later repaid when the bond matures. Inflation-linked bonds are typically issued by governments or companies.
The complicating factor for inflation-linked bonds is that the par amount borrowed will maintain its purchasing power throughout the bond’s life. This is because it adjusts daily, with the path of inflation.
The coupon also benefits from inflation-linkage as the amount paid (in pound and pence terms) is calculated by referring to the inflation-adjusted principal or par amount. This is different from ordinary bonds where the par amount and the per cent coupons paid on that par amount do not see any uplift to take account of inflation.
At maturity, the amount repaid will compose of the initial par amount plus the increase in inflation. It is this linkage to inflation that makes it different to a conventional bond and provides investors with a very useful tool to have in their kit.
Inflation-linked bonds issued by governments are large, highly liquid investments that are considered risk-free in terms of counterparty risk. Many governments issue inflation-linked bonds, the largest issuer being the US government where the market is now more than $1.7tn (1.35tn) in size.
Bond exposure
It is therefore relatively easy to broaden an investor’s exposure to different economic environments and consequently different monetary policies. The future path of growth and inflation are highly uncertain at this point – in fact, opinions vary wildly at the moment, so a prudent approach would be to increase diversification across economies, across currencies and across markets.
Exposure to bonds with different features can also be useful. For example, deflation floors may be attractive as they limit the downside risk for the investor in a deflationary environment while still offering useful inflation protection in an environment where inflation is rising. Alternative inflation indices could offer more protection.
The key benefit, and why we like them so much, is that they can create certainty for the investor, irrespective of how much inflation there may be in the future. The yield to maturity of the bond is fixed in real terms.
In other words, if you buy a bond with a zero real yield to maturity, as you can do in the US currently, you have locked in a real rate of return. This differs from other bonds, which can guarantee only a nominal, or before inflation is considered, yield.
With inflation-linked bonds, should inflation turn out to be 1 per cent annualised for the next six years, your return would be 1 per cent annualised. Should inflation turn out to be 4 per cent annualised over the next six years, your return would be 4 per cent annualised.
The impact of inflation can be hugely corrosive over time, even at relatively low levels.The certainty of outcome before the effect of inflation is incredibly valuable at a time when the path of inflation is so uncertain.
The effects of inflation on a fixed stream of cash flows can be quite severe, especially when inflation shocks persist for multiple years. Much like comparing a US equity fund to the S&P 500, one can compare a nominal bond return with inflation.
If a US equity fund returned 10 per cent in a given year you might think that this was a great outcome but if the S&P 500 had returned 12 per cent you would be focused on the negative 2 per cent performance relative to S&P benchmark.
Similarly, if a nominal bond has a yield to maturity of 3 per cent but inflation is running at 5 per cent, you would focus on the negative 2 per cent ‘real return’.
Why is this important and why should investors even think about inflation when central bankers initially told us that it was transitory?
It is worth remembering that the impact of inflation can be hugely corrosive over time, even at relatively low levels. This is basic mathematics, but unfortunately for investors the outcomes can be severe if they are not understood fully.
For example, at an inflation rate of 3 per cent, it would take just 15 years to erode the purchasing power of a pound by a third. This is why we think it is important for investors to consider the impact of inflation on their portfolios or at least think about how they can mitigate it in an environment where inflation is no longer at very low levels.
How to measure inflation
Inflation is measured in slightly different ways depending on the country and the methodology used, but ultimately it is trying to assess the average price changes within an economy.
For example, in the US, the owner's equivalent rent of residences – the hypothetical amount a homeowner could get for their house if they rented it out – has a weighting of around 24 per cent in the US CPI.
In the Eurozone, the actual rentals for housing currently has a weighting of around 7 per cent. In the UK, the equivalent rental weight is around 8 per cent but there is also an additional series for house price depreciation, which takes the total weighting to around 10 per cent.
An important point to note is that the basket of goods and services recorded by the authorities or statistical agencies may not represent an individual’s basket, therefore the headline inflation rate or the average change of prices in an economy may over or understate the individual’s own particular rate of inflation.
Inflation tends to have more of an impact on the poorer members of society.There is unfortunately no perfect way to measure inflation and as with all forms of statistics, an ‘average’ rate can hide a multitude of different rates of inflation for individual items within the inflation basket.
Changing consumer habits may also mean that particular items may drop out of ‘official’ inflation baskets, but that does not mean that consumers have stopped buying those items, it just means they have become less popular.
It is also an unfortunate fact that inflation tends to have more of an impact on the poorer members of society, as they tend to spend more (in percentage terms) of their income on food, fuel and essentials, rather than discretionary items.
Food and fuel are unfortunately very volatile in terms of their price behaviour and this is why many statistical agencies produce core inflation measures that exclude the volatile food and energy components.
If we are entering a period of stagflation – where central banks seek to combat periods of higher inflation with higher short-term interest rates, but in doing so ultimately reduce the prospects for economic growth – policymakers could conceivably be forced towards an informal (some would say reluctant) accommodation of higher inflation.
An asset class with some degree of certainty in terms of its real rate of return can offer a refuge in what is a highly uncertain environment.
Thomas Wells is manager of the Sanlam Global Inflation-Linked Bond fund
