Time to consider inflation-linked bonds?

Key points:

• Financial markets are gripped by whether the recent jump in inflation is transitory or a longer term phenomenon
• While inflationary pressures are building, the inflation-linked bond market suggests that investors appear to be placing more weight on the transitory nature of inflation
• 10-year inflation-linked bonds are likely to outperform in periods when inflation is well above the central bank inflation target
• Inflation-linked bond prices appear rich with inflation-linked bonds already anticipate that inflation will stay at around 2.5% for some time
• Inflation-linked bonds appear worth considering over the long term given their potential to perform at least as well as sovereign bonds and the uncertainty that lies ahead for investors.

Financial markets are gripped by whether the recent jump in inflation is transitory or a longer term phenomenon as economies reopen and COVID-19 restrictions ease. The answer to this puzzle matters for bond investors and changes in the outlook for inflation can spark higher market volatility.

April’s US inflation jumped the most since 1981 on a month-on-month basis. Recently, higher rates have been driven by stronger trending breakeven yields (market-implied inflation). With the 10-year breakeven inflation rate having reached the highest level since 2013, the question is whether the level will be matched by real inflation over the longer term and if inflation-linked bonds are still a good hedge against rising inflation.

Growing demand

Demand for inflation-linked bonds is typically found from pension funds and asset managers. That said, recent flows into the bonds are being driven by retail investors.

This extra demand has come as the US Federal Reserve has increased its holdings, the central bank now owning around a quarter of US inflation-linked bonds, from 10% of them at the end of 2019. Another sign that the inflation trade, at least in the short term, seems crowded is the 40% increase in inflation swaps volumes (commonly used among tactical hedge fund investors) compared to pre-COVID-19 crisis levels.

While inflationary pressures are building, the inflation-linked bond market suggests that investors appear to be placing more weight on the transitory nature of inflation. While in the past breakeven yields of longer tenors, like 10-year bonds, were trading above the shorter tenors, this year the breakeven yield curve has been inverted.

The 2-year breakeven trades roughly 30 basis points (bp) higher than the 10-year breakeven rate, implying that inflation is likely to moderate again. The potential to profit from investing in short tenors seems limited for now.

Overpricing inflation risk

Breakeven yields seem to have overpriced realised inflation that followed in subsequent years. Admittedly inflation trended lower in the respective period.

In periods when inflation stays above the central bank target, 10-year inflation-linked bonds are likely to outperform their nominal peers, as seen in different inflation eras over the last 20 years.

Long-term play

In periods of above-target inflation, some of the investment rationale for inflation-linked bonds lies on their performance against peers.

While inflation has only recently started to increase and while it is still not clear whether inflation will stay at around 2.5% or higher for long, inflation-linked bonds are already anticipating such a move. This suggests that inflation-linked bonds are rich in pricing.

However, over the long term, inflation-linked bonds perform at least as well as sovereign bonds and with the additional potential of “known unknowns”, inflation-linked bonds might be worth considering.

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