Investors are completely wrong to worry about the threat of inflation to their portfolios, according to Henderson’s John Pattullo, who has been upping his exposure to longer-dated bonds as he believes yields will continue to fall. 
Over recent years, the consensual view is that inflation will ultimately increase following the huge levels of money printing from the world’s central banks.
However, as the velocity of money has stayed low, energy prices have fallen, over-capacity levels in the global economy have stayed high, debt levels have increased and the population is ageing, headline inflation levels across the developed world have actually been falling.
That being said, there are signs this trend is reversing.
Recent figures (for a period prior to the EU referendum) showed inflation in the UK has increased from 0.3 per cent to 0.5 per cent. What’s more, the Brexit-induced sterling weakness is likely to have a further impact in the next set of data.
Relative performance of sterling over 1yr
Source: FE Analytics
If this were to happen, it could cause major issues to the UK economy as wage growth is still poor and economic growth is likely to be hit by the long-term consequences of the country’s decision to quit the EU.
Many industry commentators have therefore been urging UK investors to inflation-proof their portfolios, but Pattullo – who co-manages the likes of the Henderson Strategic Bond fund and the Henderson Diversified Income Trust – says these fears are massively overblown, especially in regard to the impact it would have on traditional fixed income assets.
“There are lots of people who think interest rates are going up and inflation is coming back. If you have read any of the stuff we have written over the past five years, you’ll know we think the complete opposite,” Pattullo (pictured) said.
“We think bond yields will continue to fall. We think inflation is not a threat at all. We think you want to lock-in good coupon yields.”
Many have been betting against bond markets for a number of years now but, despite all the negative sentiment around them, the 10-year UK gilt yield has dropped to one of its lowest ever levels – just 0.84 per cent at the time of writing.
10-year UK gilt yield over 1yr
Source: FE Analytics
The reasons behind this trend include a general flight to safety following the shock Brexit result plus the expectation within the market that Mark Carney and the Bank of England will cut interest rates from 0.5 per cent 0.25 per cent in August.
However, if inflation were to rise, it would create pain for bondholders (especially at current yield levels) as their capital would be eroded over time.
The likes of Adam Chester, head of economics at Lloyds’ commercial banking arm, warns that inflation is indeed going to rise.
"Some softening in the labour market is needed to help keep inflation pressures at bay. Yesterday's inflation report hinted that the rate of inflation is turning higher,” he said.
“The sharp fall in the pound since the referendum is likely to push import prices and inflation up further over the coming months. With the unemployment rate dropping to 4.9 per cent and wage growth picking up - partly in response to the introduction of the new Living Wage - there is a risk that, in the absence of a softening in jobs growth, inflation pressures could build more sharply."
Viktor Nossek, director of research at WisdomTree Europe, is more emphatic, though – suggesting the outlook for fixed income is much worse than current prices dictate.
“The latest move upwards in CPI inflation is above expectations, driven by climbing petrol prices and an uptick in consumer spending, and we think this is just the start,” Nossek said.
“With the pound down more than 10 per cent against the US dollar since Brexit, investors need to prepare themselves for inflation to climb rapidly, and we could see CPI move up sharply over the coming months as the impact of weak sterling feeds through into the real economy.”
However, while Ben Brettell – senior economist at Hargreaves Lansdown – warns inflation levels could rise dramatically over the coming months, it is only likely to be a technical, short-term phenomenon.
“Sterling’s weakness means higher import prices, and this is expected to feed through to significantly higher inflation figures in the coming months. Forecasts suggest it could reach 3-4 per cent. However, this will be a temporary factor – assuming sterling remains weak, the effect will fall out of the year-on-year calculation in the second half of next year,” Brettell said.
“Underlying inflationary pressure is hard to see, with Brexit-related economic uncertainty likely to dampen both consumer spending and wage growth in the short term. As such the Bank of England is almost certain to ignore what should be a temporary spike in inflation when it sets monetary policy.”
As such, Pattullo says he is favouring longer-dated bonds as he thinks current yields will only become more attractive as economic growth, and inflation levels, remain subdued over the longer term.
“Opportunity wise, I think going forwards we still have a preference for duration, or interest rate sensitivity, over default risk,” Pattullo said.
According to FE Analytics, Pattullo has returned 93.12 per cent to his investors, beating his peer group composite by some 40 percentage points in the process.
Performance of Pattullo versus peer group composite over 10yrs
Source: FE Analytics
In the likes of his £1.6bn Henderson Strategic Bond fund, which is ahead of the IA Sterling Strategic Bond sector over one, three, five and 10 years, his two largest holdings are UK gilts – one of which has a coupon of 3.25 per cent that is set to mature in 2044.
Across, his top 10 holdings, for example, the average maturity date is in 2038. Thanks to high weightings to BBB and BB rated credit, the fund also yields 4.80 per cent.