The current price of inflation-linked bonds indicate that inflation will hit 7% next year, which will cause painful disruption to markets, households and students, according to Mark Benbow, high yield portfolio manager at Aegon Asset Management.
He said Gross Domestic Product (GDP), Retail Price Index (RPI) inflation swaps imply a surge in inflation in 2022 and explained that that RPI-linked loan holders will be “particularly exposed” to much higher borrowing costs.
UK RPI year-to-date
Source: FE Analytics
“You don’t need to look far to see inflation – commodity prices are rising rapidly, as are other input costs such as shipping,” he said. “And with the rising cost of living, it’s only a matter of time before employers realise that they will need to increase wages.
“That may sound like a good thing, but consider that index-linked bonds are implying that RPI will hit 7% in 2022. If that comes to fruition, it will disrupt markets, households and students, who are painfully charged student loan interest on an RPI +3% basis, meaning they will be paying interest of 10%.”
Corporations will also feel the pain, but Benbow said it depends on how much of the rising costs companies can pass on to consumers.
The third quarter earnings will give some indication to investors, but Benbow is expecting to see “quite a bit of margin compression”.
He said: “The scary thing is that if you are a 10% margin business which is 7x leveraged and your margin goes to 5% – which is very easily done – you effectively double your leverage.
“Real yields simply aren’t high enough to compensate investors for this.”
In his view, bond markets should reprice to a more appropriate level given the risks, particularly in the US. However, he said central banks have found themselves in an uncomfortable position.
“Central banks are now in trouble if they reduce quantitative easing (QE), which would see yields rise and destabilise asset prices, and in trouble if they don’t,” he explained.
“Ultimately, the low cost of capital is underpinning everything but how can you justify such a low cost of capital when real yields are so negative?”
He continued: “As we know from 2018, even a small rise in the cost of capital is a very nasty thing for asset prices – and valuations today, in real yield terms, have never been so expensive.”
With this backdrop, the high-yield bond manager revealed that his team was looking for opportunities in companies benefitting from rising prices, and avoiding those with exposure to disrupted supply chains.
“We like companies that make the commodities that are rising fast in price and are thus beneficiaries of inflation in areas like coffee, corn, cotton and metals – and we like shipping, which is doing very well,” he said.
“We also like household names which aren’t affected by supply chain problems, like David Lloyd and PureGym, which still provide a yield of 5% or more.”