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The likelihood that the US Federal Reserve will continue to “sit on its hands”, and the market’s potentially misguided belief that inflation will be subject to continued downward pressure means US inflation-linked bonds are presenting some of the most compelling opportunities in the government bond space, according to Barings’ Christopher Mahon.
Mahon – who is director of asset allocation research at Baring Asset Management and co-manages the Baring Multi Asset Fund - says that US inflation-linked bonds (or ‘linkers’) are subject to “a rare combination of events” that is creating a number of favourable opportunities.
As a result, his £158m Baring Multi Asset Fund has 10.8 per cent in US index-linked bonds at the moment. The bond through which the fund takes this position - US Index Linked 3.375% 15.04.32 – is the second largest individual position in the portfolio.
Source: Baring Asset Management. Data to 31 July 2016
The years since the global financial crisis have seen the world’s central banks take interest rates to record lows – with the Bank of England recently cutting the base rate down to 0.25 per cent – and embark on quantitative easing programmes in a bid to bolster economic growth.
At the moment, more central banks are continuing to pledge low interest rates for the foreseeable future than are raising them while the Federal Reserve (Fed) is at pains to stress than its own rate hikes will be carried out at a very slow pace.
Explaining the reasoning behind his investment case for linkers, Mahon said: “This type of environment where banks are cutting interest rates is obviously very good news for all fixed income assets. But the real question is: which of those fixed income assets are going to be the ones that fare the best?”
“It comes down to this idea that the Fed will sit on its hands.”
“What this sets up is the perfect conditions for the linker market: conditions where the Fed does very little and where the more economically sensitive measures of inflation including CPI outperform the measures of inflation that the Fed watches and market expectations. This will deliver what we think are going to be the best returns over the next year or so within the government bond area.”
The manager has three reasons why the current conditions could favour US inflation-linked bonds, and in this article we take a closer look at them.
1. The Fed is in no hurry to raise rates
The Fed uses the personal consumption expenditure price index (or PCE) as its inflation measure, not the consumer price index (CPI) that is referenced by the linkers market. PCE inflation remains “stubbornly” below the 2 per cent level targeted by the central bank, Mahon, notes, which means it will be unlikely to lift rates unexpectedly.
“The Fed might well raise rates from time to time. If they raise rates every nine to 10 months, I'm sure that's something the market could easily take in its stride even though it might be a little bit more than is supposedly priced in,” he said.
“The bigger point is that the Fed will go slow and is seen to be reliable and unlikely to change tone aggressively, which sets up what we think are quite interesting opportunities in interest rate sensitive areas including linkers, high yield, emerging debt and other assets like real estate investment trusts.”
2. The market is underestimating inflation
In the US, core CPI inflation – which excludes the volatile price changes in fuel and food – stands at 2.3 per cent but headline CPI is 1 per cent because of the effect of recent oil price falls. Barings expect headline CPI to move closer to the core level once the falls in the oil price drop out of the 12-month look back period.
Source: Baring Asset Management. Data to 31 July 2016
As their name suggests, inflation-linked bonds are a form of government bond where the principal (or the final payment at the bond’s maturity) and its coupon (or the interest rate paid during the life of the bond) are linked to an inflation index.
However, the market is expecting inflation to be much lower than this and is pricing in CPI inflation of just 1.3 per cent. This is 100 basis points below where Mahon thinks it will be, and suggests US linkers are already trading at attractive levels.
“The market has got itself into a mode where it is expecting a lot of disinflation to come,” he added. “The market believes we're in a world of significant and sustained disinflationary forces. In our opinion, there's certainly a grain of truth in there but the market has gone a little bit too far and has overegged it.”
3. The “extreme” PCE/CPI wedge
The different inflation scenarios being present by the Fed’s preferred PCE index and linkers’ CPI measure have rarely been so divergent, Mahon says. As CPI is the higher of the two, this is to the benefit of owners of inflation-linked bonds.
Another attractive feature is that CPI tends to be more economically sensitive than PCE, owing to the different ways their baskets are constructed. In a world where the US economy is widely expected to continue to strengthen, this is an attractive feature.
“A quirk of the statistical system for consumer price inflation in the US is that around 40 per cent of the inflation basket that linkers use is related to house prices and therefore you get this economic sensitivity coming through in terms of the gains available to US inflation-linked bonds,” Mahon added.
“They are bonds, if you like, that will pick up some of the rising pressures from asset price inflation via the housing sector and deliver a better return than other assets in the government bond market, in our opinion.”
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