Inflation-linked bonds: wrong timing or back in focus?

Key points

• With central banks hiking interest rates aggressively and inflation expectations sliding as a result – is it still worth considering inflation-linked bonds, especially with global growth prospects worsening?
• Inflation-linked bonds are designed to offer more protection from inflation than a standard bond. They also tend to generate higher returns when inflation is above the breakeven rate (a measure of inflation expectations)
• Breakeven rates in the US inflation-linked bond market are dropping. By contrast, UK breakeven rates remain relatively high and appear more expensive 
• Inflation-linked bonds are also one of the few asset classes that can provide reasonable and stable returns in a stagflationary scenario

Aggressive central banks hiking and a worsening outlook for the global economy suggests that a period of lower inflation is on the horizon. But the path to moderation is likely to remain choppy. How do inflation-linked bonds stand out at times like these?

Many central banks have picked up the pace of interest rate hikes significantly during the last two months: 50 basis points (bp) represents the absolute minimum these days it seems.

The Bank of England (BoE) hiked by 50bp, while the European Central Bank (ECB) and the US Federal Reserve (Fed) lifted rates by 75bp at their September meetings. Taken together, the three of them have hiked by a whopping 350bp since June.

The three central banks are determined to fight record inflation. While the backdrop for all three economic areas differs, to some extent time is money. And the cost of not acting forcefully and swiftly is believed to be too high.

No pain, no gain

The Fed leads the hiking cycle charge among the major central banks and does not seem to be shying away from greater growth repercussions. “No one knows whether this process will lead to a recession or if so, how significant that recession would be,” Fed chair Jerome Powell told reporters during his FOMC press conference in September. He added: “We have got to get inflation behind us. I wish there were a painless way to do that. There isn’t.”

The FOMC members project a rate of 4.6% (median) by the first quarter of next year. “The path that we actually execute will be enough”, he said when referring to the task of bringing inflation back towards the 2% target (a long way from here).

Fed’s rate projection seems realistic

The rate market won’t dare challenge the central bank’s policy rate path and prices in a peak rate close to the Fed’s “dot-plot” projection, at around 4.6% (mid-point) early next year. With such a move, the Fed’s forecast for a moderation in inflation towards 3.1% by the end of next year seems realistic, while the risk of stickier inflation remains.

Base effects, diminishing pressure from pandemic-related components like cars and airfares, but also lower trending healthcare insurance costs, as well as a cooling housing market, point to weaker price growth. Until then, the core underlying (longer-lasting) trend, as reported by recent inflation prints, seems firmly up. Meanwhile, food and energy costs remain a risk for the trend of moderation.

While the short end of the curve tries to calibrate towards the possible peak in rates, the long end is already looking beyond the period of peak inflation. This should also explain why bond investors would settle for the lower yields that longer-dated bonds offer over shorter-dated bonds. Over a five-year period, for example, it appears very likely that policy rates in any of the bond markets may fall, especially in a recessionary environment.

Cash rates high, for now

Cash rates, as implied by 2-year bond yields, may be on the up for now. However, over a longer period yields are likely to adjust downwards again. As such, cash is unlikely to perform better than what current long-end yields suggest, in our view (see chart).

Weighing up between the risk of significantly higher rates (duration or price volatility risk) and the possibility of much lower rates in three years’ time (re-investment risk) seems to be a crucial exercise. Weighing up between the two, we see value in maturities of between two years and five years at this point. As highlighted in the last Market Perspectives, we prefer investment-grade bonds, especially at current yields of well over 5%.

Time to consider inflation-linked bonds?

When it comes to diversifying bond portfolios further, inflation-linked bonds (ILBs), also known as “linkers” (in the UK), come to mind. But investors may rightly ask whether this is the right time to invest in this type of bond.

Alternatively, they might question if it is too late, given how high inflation is, that peak inflation nears, and that insurance against inflation is usually at its most expensive when the inflation house is burning. That said, there are justifiable reasons for investing in ILBs, especially to diversify bond-heavy portfolios.

In particular, the US inflation bond market has re-priced sharply downwards which reflects the market’s conviction that inflation will plunge (see chart).

For instance, 2-year breakeven rates, which reflect the difference between yields from nominal bonds and linkers, imply that inflation will average 2.3% over the next two years (although the number is partly distorted by the time lag evident within the inflation linked bond market).

The substantial retreat from levels over 5% suggests that there is much confidence that inflation is declining on the back of a recession, higher policy rates, or both, which is not set in stone. Similarly, the 10-year breakeven rate implies an average inflation rate over the next ten years of 2.4%.

How are nominal and real yields connected?

Holders of nominal bonds would usually expect a coupon or yield that compensates for the inflation anticipated if held to maturity. Investors, on the other hand, might focus on the possibility or risk that the embedded inflation premium in nominal bonds (for example 2.4% breakeven for 10-year bonds) does not reflect the anticipated path of inflation, and turn to ILBs instead.

So, keeping an eye on the real yield, the breakeven rate, and the nominal yield matters when deciding whether to invest in ILBs or not.

Prepare for the almost unthinkable

The question remains as to whether inflation compensation of 2.3%, as offered by the US 2-year nominal bonds in the earlier example, seems sufficient. In the last two years, the path of inflation has been particularly difficult for investors and central bankers to predict. It is the optimistic pricing of inflation seen in recent times, that offers value in the US inflation-linked bond market, in our opinion.

While not our base case, a higher inflation trajectory, despite lower growth, is still possible. In such a stagflationary scenario, inflation linked bonds are one of the few asset classes that look likely to provide reasonable and stable returns.

UK environment looks different

By contrast to the US market, UK breakeven rates still appear high (with a 10-year breakeven rate of 4.15%), especially given the UK government’s capping of energy bills, which is likely to lead to softer inflation. Admittedly the announced measures including debt financed tax cuts may add to inflationary pressures over the medium term again.

Overall, the outlook for the economy seems very vulnerable with the BoE projecting a recession going into 2024. The next chart illustrates the difference in the pricing among various countries by comparing the current breakeven rate against the most recently reported inflation figure.

While Italian breakeven rates might seem comparatively cheap, the inflation-linked bonds are not insulated from the risk of yet more government debt in the country and the uncertain political backdrop.

Performance of inflation-linked bonds

US real yields have recently hit levels not seen since 2010, potentially suggesting entry levels again. Since 2010 Bloomberg’s US 5-10-year inflation linked-bond index has returned 3.13% annually over that period, outperforming nominal bonds by 1.23% a year on average (see table). This is even more remarkable given the period experienced was characterised by lower-trending inflation.

Past performance patterns may not serve as a blue print for what follows. It is also important to note that inflation-linked bonds are not a hedge against inflation as such due to the bond component (real basis). But the inflationary environment has arguably been more uncertain than ever this year.

As such, adding inflation-linked bonds at higher and positive real yields seems a reasonable option, as opposed to purely holding nominal bonds in a portfolio.

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