Fixed Income  

Understanding bonds in an inflationary environment

  • Describe some of the challenges with bond investing currently
  • Explain duration
  • Identify the significance of inflation-linked bonds
Understanding bonds in an inflationary environment
(FT montage/Tolga Akmen/EPA-EFE/Shutterstock/Dreamstime)

What has triggered the unleashing of inflation to the highest level in 40 years? 

Supply-side constraints from the sudden post-Covid restart was the spark; a global energy crisis was the flame; easy money (quantitative easing) was the paper; and the Russia/Ukraine war and related sanctions has been the petrol poured on top. The combination could not be worse.

These political and economic factors have led to a surge in inflation worldwide. 

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Its negative impact has been compounded by the policy errors of central banks that were first behind the curve (labelling inflation as 'transitory', when it was anything but), and now so hawkish (which will do little to solve the energy crisis) that they now risk raising rates so aggressively that they will choke off growth.

The era of 'Goldilocks' monetary policy and the 'great moderation' (the steadily declining interest rates and inflation, enabled by globalisation from 1990s to 2020) may indeed be over.

It will be for economic historians to make sense of what led to this chain of events, decisions taken, causes and effects and parallels with the 1972-73 oil shock that was the trigger for the previous bout of high inflation.  

What can advisers do to help?

In the meantime, our focus should be on end-client needs and portfolio solutions to help keep financial plans on track.

Advisers’ clients are facing a cost of living crisis as real incomes decline. The combination of higher taxes, rising interest rates and rising fuel, food and energy costs means net take-home pay is declining and disposable income is plummeting.

Facing the increased likelihood of a recession, the risk of a loss of income altogether only raises anxiety.

From a financial planning perspective, this is a crucial time for financial advisers to support their clients and help navigate through uncertain times.

Older advisers with older clients who can together recall the UK’s battle with inflation in the 1970s should be better equipped to cope with these markets.

Younger advisers should consider some lessons from the past on how to mitigate inflation risk. But this requires a fundamental rethink of how asset classes behave compared to in more normal times.

The challenge for nominal bonds

In low inflation regimes, cash and nominal bonds (such as corporate bonds and gilts) are lower risk and equities are higher risk. In higher inflation times, cash and nominal bonds are higher risk and equities are lower risk.

This seems paradoxical. But by risk, we do not mean volatility (although inflation is in a way the 'volatility' of cash), but preservation of capital in real terms.  

The reason why cash and traditional nominal bonds, are higher risk during an inflationary regime is because they cannot keep pace with inflation. Put simply, the positive yield on cash (if any) or on traditional bonds is more than offset by the negative adjustment for inflation. This is why 'real' (inflation-adjusted) yields are negative.