The spectre of inflation risk – or the erosion of returns due to a higher general rise in the prices of goods and services – is a distant memory for UK investors with the need to protect against it low on their priority lists.
UK inflation, as measured by the consumer prices index, stood at just 0.3 per cent in January, the lowest level since 1996, when the Office for National Statistics began recording the data, with further falls expected due to lower crude oil and energy prices.
In fact, Bank of England governor Mark Carney is expecting the rate of inflation to temporarily turn negative at some point in the next six months, making deflation a greater headline worry than sharp inflation.
However, since January 2015 AXA’s bond team has been slashing allocation to regular fixed income across its fund range and are now fully invested in inflation-linked bonds, which Baltora believes are cheap despite a good run in 2014.
“We believe that as investors are worried about rates potentially going higher at some point in the future, inflation-linked bonds can protect from one of the two factors potentially sending yields higher, namely real yields and inflation expectations,” Baltora said.
He adds that the inflation-linked bond funds he manages have been holding up to 15 per cent in nominal bond holdings, the usual type of fixed income securities, of late due to a desire to hedge the portfolio against the impact of falling oil prices, but this has now reversed.
“We have now fully switched back into inflation-linked bonds. We think inflation-linked bonds are globally attractive at this point as embedded inflation expectations trade well below central banks targets and the ever-expanding central banks’ balance sheets should also remain supportive for real interest rates,” he said.
According to FE Analytics, the IA UK Inflation Linked Gilt sector was the best performer in 2014 out of any sector with a 18.56 per cent average gain.
Over the longer term the numbers are less favourable with the IBOXX UK Corporate Bond index ahead over three years compared to gilts and linkers, as the graph below shows.
Performance of indices over 3yrs
Source: FE Analytics
Since 1998 – as far as our data goes back – the index-linked market has tended to stay ahead of other parts of the fixed income space, which Baltora says will continue and that a buying opportunity has opened up recently.
Performance indices since 1998
Source: FE Analytics
“Inflation-linked bonds have naturally been underperforming their nominal counterparts in this environment for the last few years. We believe that this trend may well be over as inflation break evens currently trade well below the central banks’ target and the recent oil price correction is fully priced-in,” Baltora said.
“While year-over-year headline inflation will likely remain below 0 per cent for some time, we believe monthly inflation, feeding inflation-linked bonds coupons, is expected to rebound strongly in the coming months. Investors would therefore be well compensated for buying cheap medium-term inflation protection explaining why demand for the asset class has picked-up,” he said.
“Inflation-linked bonds have outperformed nominal bonds in February as investors are taking advantage of historically low valuations and central banks are rushing to cut rates and ease monetary conditions to prevent their currency from appreciating. Inflation linked bonds are often an attractive value proposition in a currency war situation.”
Baltora says value also exists in the eurozone and US linkers market.
“The US dollar has strengthened by 20 per cent since December 2011, however the US TIPS market has underperformed nominal treasuries by more than 4 per cent. We also see opportunities in US TIPS as inflation break-evens are too low when compared to the Federal Reserve mandate. US TIPS should benefit from relatively cheaper real interest rates. We believe that inflation break evens should gradually widen as inflation pick-up drives investors into the asset class again.”
He says the eurozone linkers market can offer protection against rising yields as the European Central Bank will try to prompt higher inflation before its halts its recently launched QE programme, which he says would also send yields higher.
“We believe euro inflation-linked bonds offer value as the euro area stands to be a winner of the currency war in the year to come. Currency war spillovers have been significant in the inflation linked bond market with Japanese inflation linked bonds outperforming nominal Japanese government bonds by 9.2p per cent as the Japanese yen has dropped by more than 50 per cent over the same period against the US dollar.”