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Why you shouldn’t rush into index-linked bonds for inflation protection

18 January 2017

Analysts warn of the dangers of rushing into inflation-linked bonds as the first signs of rate rises begin to emerge.

By Jonathan Jones,

Reporter, FE Trustnet

Investors shouldn’t jump into inflation-linked debt just because inflation appears to be on its way back, according to JP Morgan Asset Management chief marketing strategist Stephanie Flanders.

Latest figures released on Tuesday by the Office for National Statistics revealed UK consumer price inflation rose to 1.6 per cent for the 12 months to December from 1.2 per cent in November - the highest rate since July 2014.

CPI inflation rate since January 2014

 

Source: Office for National Statistics

With this dramatic shift in inflation expected to take place this year, many investors could be tempted to turn to inflation-linked debt, but Flanders says this could be a mistake.

“A lot of clients will say ‘well if we’ve got rising inflation then surely that’s the time to rush into index-linked debt if we want to protect our bonds’,” says Flanders.

“You’d be surprised when talking to clients how quickly people jump to the index-linked without really thinking about it.”

“But what matters is how far breakeven expectations are now – what sort of price are you buying those bonds at - and I think if you look in the UK case you could argue that those expectations are already quite high.”

The Bank of England expects CPI inflation to exceed the 2 per cent target by the middle of the year, although Ben Bettrell, senior economist at Hargreaves Lansdown, says he wouldn’t be surprised if it happens sooner.


He said: “December’s producer price data contains a strong indicator that higher inflation is coming.”

Indeed, some analysts are now suggesting that inflation could reach as high as 4 per cent by the end of 2017.

Flanders (pictured) says inflation expectations are already being priced into inflation-linked debt, making it less secure than some investors may think, adding that investors need to look at what is driving yield increases.

“If quite a lot of this rise is actually coming from an increase in the term premium or an increase in the real rates then you are not protected from that if you are holding index-linked gilts,” she said.

“You are only really protected and you certainly only really make money from index-linked gilts if you have a rise in nominal rates which is actually coming with a fall in real rates which is not the case here.”

Flanders points to US Treasury inflation-protection securities (TIPS) as an example of when buying into inflation protection at times of rising inflation can be a boom-or-bust proposition depending on the factors driving these price rises.

“We work through a very simple example of what you would have returned from index-linked and regular debt,” she explained.

“In 2009 when you had a change that was pretty much entirely driven by different inflation expectations, then you were protected and indeed you made money on inflation-linked debt.”

“In the Taper Tantrum where it was almost entirely a real increase you lost a lot more money on index-linked.”

“And this latest rise - in so far as you can make these assessments – is about 50/50 so you are not particularly protected.”

Psigma head of investment strategy Rory McPherson adds that investors need to determine whether inflation is truly back for good before buying index-linked debt.

“In the US – most definitely – the economy there has been really strong for some time, it’s nothing new. In the US inflation comes with growth, with an economy moving at full capacity - almost full-tilt - and this is why inflation is going to pick up there.”


“In the UK not so much of what you’ve seen is a huge ramp up in expected inflation and a lot of that has been currency led.”

“You’ve had a 20 per cent weakness in the pound versus the dollar which tacks on about 2 per cent to inflation over the course of the next 18 months and that’s what markets have priced in.”

“So how do you play it? This is an interesting one because anything with inflation in its name can be a very dangerous way to play inflation.”

He adds that some of the best performing assets over the last few years in a period of deflation have been index-linked bonds, particularly in the UK, which have lost as much as 15 per cent in the last four months of 2016.

Performance of Barclays Global Inflation-Linked Hedge index over 5yrs

 

Source: FE Analytics

“You have to be quite specific about how you do it so what we do is pick a manager that plays specifically the breakeven rates in the US market,” McPherson said.

The analyst suggests the Fidelity Global Inflation Linked Bond fund, run by Timothy Foster and FE Alpha Manager Ian Fishwick.

While the $1.1bn fund has underperformed its benchmark over the last five years, McPherson says looking ahead it should be a beneficiary from prolonged US inflation.

He said: “This is tapping into the US where we believe we are going to get wage-driven inflation - so proper inflation - that hangs around for a long time. This is going to strike in the US and is going to feed through into this fund.”

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