6 December 2016
For years, central banks have tried every trick in the book to fight off deflation, and it looks like they have succeeded. Inflation finally appears to be rearing its ugly head once again. Readings have picked up in the eurozone as well as in the UK, and bond markets have been quick to react. An additional twist is the election of Donald Trump. His mooted multi-trillion, debt-financed fiscal stimulus programme to rebuild the ageing US infrastructure has sounded some alarm bells in US Treasury markets. They worry that in combination with plans to cut corporate taxes, the election programme does not bode well for public finances and could promote inflation.
As the correction has started shaving off some of the generous year-to-date bond market profits, investors are scrambling to re-evaluate their fixed income allocations. With inflation back on the agenda, inflation-linked bonds – also called linkers – are also returning to the spotlight. Are they the solution?
Relative versus absolute attractiveness
In short, we see them as a solution for investors with existing developed market nominal bond allocations. But let’s first bust some myths: A country’s inflation rate on its own is not the proper tool to assess the relative attractiveness of a linker versus its conventional nominal peer. To make that call, we need to look at breakeven inflation rates. The lower they are, the cheaper the linker or the cheaper the inflation protection will be.
But before looking at the relative attractiveness, it makes sense to analyse first which markets are the most attractive on an absolute basis, ie where should one get involved based on available yields? The measure to assess absolute attractiveness is real yields – the higher real yields are, the more attractive the linker will be.
Based on this consideration, our assessment of the absolute attractiveness of the four main markets (USD, GBP, EUR, JPY) is as follows: Real yields are generally quite expensive, in particular in those markets driven by QE (UK and eurozone), where they are firmly in negative territory. Therefore, linkers are not particularly attractive in absolute terms, similar to their nominal peers, and remain vulnerable to a rise in real yields. This rise could be triggered by another ‘tapering’ moment once the various central banks announce the end of their QE efforts.
Of the four markets, the US stands out as the most attractive at 0.9% real yield based on the 5-year real yield 5 years forward. The US market has already had its tapering when real yields adjusted sharply in 2013. Outside of the major markets, New Zealand is the cheapest, with real yields at 2.25% for 5 years 5 years forward.
It makes sense to replace nominal bonds with linkers
The interesting part for those investors that either have to have or would like to have exposure to developed market government bonds comes now: the relative attractiveness of linkers compared to their nominal brethren. Based on breakeven inflation rates, linkers are fair value to slightly cheap, in our view (ie long-term inflation expectations are reasonably low or even below central bank inflation targets). Therefore, they offer an efficient hedge against inflation, which means that they are likely to outperform conventional nominal bonds in case of rising inflation rates and inflation expectations. The UK is somewhat of an outlier in this group as its breakeven inflation sits at almost 3%, which we would see as approaching the expensive side of fair value.
From an asset allocation point of view for an existing portfolio, we would argue that it makes sense to replace the current allocation to nominal bonds, ie existing nominal duration risk, with inflation-linked bonds. This should avoid additional outright losses in the case of rising real yields, even when outperforming conventional nominal bonds. In this scenario, linkers play a valuable role.
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