PERSPECTIVE3-5 min to read

If inflation is peaking, why hold inflation-linked bonds?

Despite efforts by central banks, the inflation outlook remains uncertain, so a portfolio allocation to global inflation-linked bonds could make sense.

17/11/2023
Inflation linked bonds

Autheurs

James Ringer, CFA
Karen Wright
Associate Investment Director, Global Unconstrained Fixed Income

Why should investors consider inflation-linked bonds (known as linkers) when inflation pressures globally appear to be receding. Below, we discuss three reasons why it's an opportune time to consider incorporating inflation-linked bonds, also known as linkers, into your portfolio.

  1. An uncertain inflation outlook

Linkers are structured to outperform conventional government bonds, also known as nominal bonds, during periods when the actual inflation rate (typically measured by the Consumer Price Index or CPI) surpasses the expected inflation rate for that same period. The distinguishing factor of linkers is that their principal, and subsequently, their coupon, is adjusted in accordance with the inflation rate. Therefore, even during periods such as now, when inflation pressures appear to have reached their peak, but the future trajectory of inflation remains uncertain, an allocation to linkers could still be seen as a sensible choice.

Although central banks have nearly concluded their cycle of rate hikes, the risks associated with inflation remain high. The Covid-19 crisis caused a multitude of disruptions, pushing greater uncertainty around the path of inflation in its wake. Now that the supply chain issues, which contributed to higher prices during the pandemic, have normalised, the straightforward progress to lower inflation might be in our rearview mirror. However, with service inflation proving stickier for many economies around the world, there are challenges that still lie ahead.

In the US, efforts to reduce inflation seem to have plateaued, and according to some metrics, have even regressed. The Median CPI is one such measure that has seen a significant surge in month-on-month price gains. As this measure excludes outliers (i.e., the smallest and largest price changes), it can provide one of the more reliable indicators of the underlying inflation trend.

CHART1: US inflation ticking up – Median CPI

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2. The total return angle.

From a total return perspective, it is important to understand that linkers are particularly sensitive to movements in real yields (a bond’s yield after being adjusted for inflation). Their unique cashflow structure means that they are of a longer duration and so are more sensitive to changes in interest rates compared to nominal bonds with a similar maturity.

A common misconception is that linkers are inflation matching investments. This interest rate sensitivity was particularly evident during 2022 when central banks aggressively raised interest rates in a bid to tame rampant inflation pressures. Although global inflation-linked bonds outperformed nominal bonds (i.e., conventional government bonds), they still delivered double-digit negative returns.

However, looking ahead, the real yield element should be less impactful and potentially positive for linkers’ total returns as central banks stop raising interest rates. Moreover, the ongoing struggle to control inflation may create an optimal environment for global inflation-linked bonds.

Let's examine three potential inflation outcomes and assess how global linkers would fare in each:

Soft Landing - Also known as a 'Goldilocks' scenario, this is when inflation is peaking, but the economy remains resilient. Under these circumstances (our current base case), we would anticipate linkers generating positive total returns (assuming central banks pause rate hikes) but underperforming nominal bonds as inflation expectations moderate.

No Landing - Recent deterioration in US inflation dynamics has increased the likelihood of a ‘No Landing’ - scenario. In this case, we would expect both nominal bonds and linkers to yield negative returns (based on a narrative of persistently high rates), but linkers would likely outperform due to persistent inflation.

Hard Landing - The prospect of a Hard Landing has been gradually rising as higher interest rates take effect, risking a future recession. In this scenario, we would expect central banks to cut interest rates, leading to positive total returns (the highest among the three scenarios) for both nominal bonds and linkers. However, a deflationary environment would likely result in linkers underperforming.

CHART 2: How can inflation linked bonds perform from here?

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Current valuations are making linkers an even more compelling option.

Real yields are looking attractive. For the first time since 2009, US 10-year real yields have surpassed the 2% mark. In fact, real yields are positive across the entire US curve for the first time in a decade. While this is not true for all linkers markets globally, it’s worth remembering that around half of the global market is made up of the US. So, for a European investor (where real yields are comparatively lower), an investment in a global linker strategy would provide an uplift to their inflation-adjusted expected return.

US real yields as shown in the chart below, are something the US Federal Reserve (Fed) is watching closely, using them as an implicit target to assess the restrictiveness of current monetary policy settings. Recent indications suggest that the Fed is nearing the end of its rate hike cycle. This would imply that real yields are approaching their peak (yields of course are inverse to price).

CHART 3: US Real Yields over 2% across the curve for the first time since 2009

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3. Diversification

When the outlook is uncertain, it makes sense to spread your risk. It’s possible to do this through a mix of conventional government bonds and linkers. However, these diversification benefits can be vastly increased by going global.

Adopting a global approach offers the opportunity to gain from broader diversification across distinct inflation-linked bond markets. Currently, we're witnessing a divergence between a robust US economy and a more subdued outlook for the rest of the world. Given that individual economies are at different stages of the economic cycle and display unique, ever-evolving inflation profiles, it's worth exploring the use of global inflation-linked bonds to maximise returns and manage risks. The chart below illustrates the potential for enhanced returns through an active strategy across global inflation-linked bond markets.

Chart 4. Performance of global linkers

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In conclusion, forecasting inflation and determining the type of environment we're in is invariably challenging. Given the possibility that the post-pandemic era may lead to shorter economic cycles and inflation might remain structurally higher, allocating to global inflation-linked bonds could be the most appropriate strategy, especially when valuations are looking so attractive.

Autheurs

James Ringer, CFA
Karen Wright
Associate Investment Director, Global Unconstrained Fixed Income

Topics

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