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Memories are short. We are still recovering from the aftermath of the pandemic. As the global economy returns from its slumber, supply chain shocks and now geopolitical events have seen energy and food prices soar. Meanwhile, pent-up demand from long periods of lockdown were unleashed from the buildup in savings, pushing up prices.
July 21, 2022
To put this into perspective, we have not experienced this level of inflation in 40 years. Inflation psychology has shifted significantly, and while longer-term inflation expectations have not yet become unanchored, they are increasingly at risk of becoming so. In fact, this four decade-long break saw a slow decline in macroeconomic volatility – a period known as the great moderation. Interest rates also fell gradually and finally hit record lows during the pandemic.
Today, bond investors will need to adapt, as bond prices have tumbled this year (yields have risen) after many major central banks began to end large-scale asset purchases and raise interest rates in their battle with soaring inflation. This subsequently pushed yields upwards across many of the largest economies, reaching their highest levels in years.
Below are a number of fixed-income considerations bond investors might find useful for establishing a fixed income strategy.
One possibility that investors can make use of, if interest rates and inflation expectations are rising, is to reduce the duration – the sensitivity of a portfolio to a change in interest rates. Short-duration bonds can help mitigate downside risks thanks to their lower sensitivity to both rate and credit spread movements. Thanks to lower interest rate risk than traditional core bond strategies, short-duration bonds can limit capital losses from such developments. Since last November, hawkish central bank action has meaningfully flattened the yield curve, creating ample risk/reward potential in shorter-duration bonds versus medium- or long-term instruments.
A second possibility are floating rate strategies where investors could benefit from higher interest rates. Here, the rate on the floater adjusts periodically to the current market rates. Floating-rate credit offers significant yield pick-up versus money market and short-term instruments due to high-carry investments. Furthermore, floating-rate strategies with steady income streams from diversified credit exposures and limited interest rate risk do not just limit downside – they could actually deliver positive returns in such an environment.
Senior secured loans could be a third possibility. These are debt obligations generally issued by non-investment grade businesses. These loans are usually “secured” by a company’s assets and are typically used to fund a company’s growth or cover general operating expenses. They pay floating rate coupons, which can help reduce duration risk even more. Quite often, investors will invest in them alongside high yield bonds.
Inflation-linked bonds are a well-established asset class – the first “linker” was issued in the US, back in 1780. Globally, this is a USD 4.4 trillion market, which consists of a variety of bonds issued by governments, as well as several corporates.1
Conventional bonds are issued with a fixed nominal coupon and a redemption payment amount agreed in advance. These conditions take into account inflation expectations at the time of issuance, but are not subsequently adjusted. Inflation-linked bonds by contrast guarantee a fixed real return, irrespective of inflation. Inflation-linked bonds adjust coupon payments in line with realized inflation, unlike conventional bonds.
While inflation-linked bonds have considerable upside potential, they also possess certain risks. As with other investments, the price or the value of an inflation-linked bond can fluctuate over time. While the value of nominal bonds is determined by changes in real interest rates and inflation expectations, the value of inflation-linked bonds only changes when real interest rates fluctuate.
If inflation expectations remain constant, the returns generated by nominal and inflation-linked bonds are therefore identical and depend on real interest rates. This means that any differences in the returns of the two bond classes are caused solely by changes in inflation expectations. If inflation expectations rise, inflation-linked bonds outperform nominal bonds. Conversely, they perform less.
Combining all four of the approaches described above could provide a fixed income investor with a great deal of protection in a rising inflation environment. Each approach is unique and offers diversification benefits. A skilled investor can strategically invest across these four areas and protect their bond portfolio from rising interest rates or rising inflation.
To what extent and for how long will inflation rise? The uncertainty surrounding the effects of inflation has increased massively. The current situation is calling for existing investment strategies to be reviewed and new opportunities to be evaluated.
1 Ranasinghe, D., Chatterjee, S., & Barbuscia, D. (2022, February 9). Surging inflation spurs demand for once rare linker bonds. Reuters. https://www.reuters.com/markets/europe/surging-inflation-spurs-demand-once-rare-linker-bonds-2022-02-08/
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