BONDS ARE BACK
The Reasons Why You Should Switch from Inflation-Linked Bonds Now
Since the Spring of 2020, we have unsurprisingly seen inflation skyrocket.
In an attempt to provide an income to those unable to work due to globally coordinated Covid-19 lockdowns, governments and central banks across the world collaborated to print vast amounts of new money, and deposit it directly to citizens. An economic tool also known as a ‘Helicopter Drop’.
The effect of this on the bond markets was stark; ‘safe’ money was no longer safe, as the ‘real’ value of bond principals and fixed income rates have been eroded by the massive devaluation of currency.
In response, many investors fled from long bonds into inflation-linked bonds in an effort to protect their portfolios. While this worked in some respects, it failed in others – a more detailed analysis can be found here.
In short, here’s how things played out:
- Traditional bonds have two primary components: interest rate yield and price, which are inversely related. As interest rates rise, bond prices fall, and as interest rates fall, bond prices rise.
- The value of inflation-linked bonds is tied and adjusted semi-annually to the rate of inflation in a given currency.
- When inflation goes up, the value of the bond goes up, and investors receive an increased coupon payment and value at maturity if the adjusted principal is greater than the face value.
- Inflation-linked bonds have a third component that a standard bond does not - an inflation adjustment to the principle.
- Inflation-linked bonds have lost value over the last year because the price movement associated with rising interest rates is greater than the inflation adjustment to the principle, causing a negative return.
The Danger in Holding Inflation-Linked Bonds
Inflation-linked bonds can be a good way to protect your portfolio in times of high inflation. However, when inflation moves downward, the principal value and subsequent coupon payments on inflation-linked bonds are also reduced, which could mean further losses if inflation has turned over and descends towards target levels.
Where we are right now the Fed base rate is still climbing, but future increases are becoming less steep as inflation is brought down. This means:
- We will soon reach a ‘tipping point’, where interest rates peak, and inflation continues down. A move out of inflation-linked bonds ahead of this inflection point would be prudent.
- If the Fed raises rates too high or too quickly (or is deemed to by 'the market'), it will cause a decrease in consumer spending, a decrease in corporate profits, and an increase in unemployment. A cyclical low in unemployment is an indicator that an economy has peaked and may be heading into recession.
- Investment grade bonds are a safe haven in such times.
- There's an opportunity by moving into non-inflation-linked bonds, as new issue bonds have to have a high enough coupon versus interest rates & inflation to attract buyers in auctions.
- Looking for example at 10Yr US treasury bond auctions, the trend is clear; this March the coupon fixed was 3.5%, Feb 2022 it was 1.875%, Feb 2021 1.125%, Feb 2017 2.25%, Feb 2013 2%.
- Interestingly, if you go back to August 2007 – just before the Great Recession, with interest rates were at 5%, 10Yr bonds were selling at 4.75%. The Fed rate is at 5% as of today, with potential increases coming.
If markets play out like they have done in previous rate-hiking cycles, following a few years of major losses bonds may soon become the leading asset class within portfolios.
We don’t know if, when or how exactly this will happen – we don't have a crystal ball – but the logic stands to reason given all of the available data.
High-quality bonds will always play a pivotal role in portfolios, as they have shown to be the best diversifier to equity risk.
Now that bond coupons have risen (and inflation is hopefully on a downward trajectory – at least in US Dollar terms), it's best to have that portfolio protection in place before it's needed.
Disclosure: This article has not been written to give advice, and purely expresses our own opinions. We are not receiving any compensation for it, and we are not responsible or liable in our capacity as an independent financial adviser for any action taken by readers based on these opinions. For personalised advice based on these issues, please seek advice from a regulated, independent expert.