Inflation-linked bonds to the rescue?

Key points:

• Inflationary pressures are building as economies reopen and pandemic restrictions ease. Investors are focusing on whether this is transitory or not
• Demand for inflation-linked bonds has grown of late, with more interest from retail investors, as signs of mounting inflationary pressures hit financial market volatility
• 10-year inflation-linked bonds are likely to outperform in spells when inflation is above the central bank inflation target
• With the inflation-linked bond market anticipating that inflation will stay at around 2.5% for some time, bond prices appear rich
• Inflation-linked bonds perform at least as well as sovereign bonds and given the potential for “known unknowns” ahead seem worth considering over the long term.

Signs of mounting inflationary pressures, and the US Federal Reserve’s response to them, have often sparked volatility in financial markets this year.

April’s US inflation jumped the most since 1981 on a month-on-month basis. Prices are also rising more quickly in other leading economies. The question is; are elevated inflation levels transitory or longer term in nature? The answer matters for the value of holdings in fixed interest bearing securities.

In preparing portfolios for a spell of higher inflation, are inflation-linked bonds still a good hedge against rising inflation?

Demand on the up

Pension funds and asset managers typically account for inflation-linked bond demand. Of late, however, retail investors have also shown more of an interest in the bonds, going by recent flows.

The US Federal Reserve has also been increasing holdings in inflation-linked bonds (or linkers) and now owns around a quarter of US linkers, from 10% of them at the end of 2019. A 40% increase in inflation swaps volumes (commonly used among tactical hedge fund investors) compared to pre-pandemic levels is another sign of a crowded inflation trade, at least in the short term.

The linker market suggests that investors are placing more weight on the transitory nature of inflation. In the past, breakeven yields of longer tenors, like 10-year bonds, traded above shorter tenors. However, this year the breakeven yield curve has been inverted.

The 2-year breakeven trades roughly 30 basis points higher than the 10-year breakeven rate, implying that inflation is likely to moderate again. The potential to profit from investing in bonds of short tenors seems limited for now.

Breakeven yields overpricing inflation risk

Breakeven yields seem to have overpriced inflation that subsequently occurred in following years. Admittedly inflation trended lower in the respective period.

In periods when inflation stay well above the central bank target, 10-year linkers are likely to outperform their nominal peers, as evidenced in the performance of the linkers against nominal bond counterparts in different inflation regimes over the last 20 years.

Long-term attractions

When inflation is above the central bank target, some of the attraction of investing in linkers lies in their performance against nominal sovereign bonds.

Though inflation is on the rise and it is unclear whether it will stay around 2.5% or higher for long, inflation-linked bonds are already anticipating such a move. This suggests that linker prices are rich.

Linkers perform as well as sovereign bonds or better over the long run. Add in the potential of “known unknowns” ahead elevating uncertainty and the bonds seem worth considering.

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