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What’s happening with inflation-linked bonds?
The first quarter of 2022 was likely the most difficult period in most financial professional’s career. With the majority of investors and asset allocators having only seen market corrections recover quickly, the events of February 2022 resulted in the worst period for both bond markets and the traditional ‘balanced’ portfolio in history.
Outside of Ukraine, which the market has seemingly moved on from, the two driving factors were clear, interest rates and inflation. For years, perhaps decades, investors have been warned about the threat of higher rates on valuations, with the pandemic-driven supply chain inflation seemingly the straw that broke the camel’s back.
Not many asset classes were immune from the selloff, with gold a rare winner, but one of the unexpected underperformed was the inflation-linked bond market. For those who are unaware, global governments and corporates are able to issue bonds that are referenced to inflation, potentially providing the ‘perfect inflation hedge’ to investors.
Whilst the interest rate on said bonds is fixed, the capital or par value is increased (or decreased) usually on a quarterly basis depending on movements in the CPI. That is, if inflation is increasing, the value of the bond and therefore interest payments also increase. The thing is, in the March quarter, they didn’t.
One of the more popular inflation-linked bond options in Australia, which is quite a shallow market it must be said, fell some close to 9 per cent during the quarter and or around 7 per cent when distributions were included. Yet why was a hedge against inflation devalued at a time when inflation was clearly increasing along with interest rates?
There are a number of reasons, but among the most important is the fact that despite the inflation linkage, these bonds still trade like any other government-issued security. In fact, the underlying index actually has longer duration, at nine years, than the Composite Bond index. That means, an increase of 1 per cent in the bond yield, which moved from around 2 to 3 per cent in a short period of time, will result in losses of up to 9 per cent in capital value.
This is explained by what is known as the ‘real yield’ on offer from the market. The real yield is simply the current interest rate available from say a 10-year bond, 3 per cent (the nominal yield), less the rate of inflation. In most parts of the world the real yield has been and will remain negative for some time, but the more important issue for investors is that it is gradually moving towards being positive as bond yields increase around the world. That is, the negative impact of movements in bond yields offset the positive impact of inflation.
Similarly, an underappreciated aspect of the inflation-linked bond market is that it is typically utilised by more sophisticated traders as a hedge against future inflation, not against inflation that is already here, hence many likely sold out of their positions once inflation emerged.
