Philip Brown, Head of Research at FIIG Securities, says there are options for investing in bonds that provide direct inflation protection or indirect protection via exposure to floating interest rates.
An inflationary, but otherwise benign outlook, lends itself to taking bond risk with things other than only fixed rate bonds.
Considering other types of bonds
For an environment where a “higher inflation for longer” profile is a material risk, there should be an increased desire for other types of bonds, in particular floating rate notes (FRNs) and inflation-linked bonds.
But the key question for investment is to always check what the market is currently expecting. After all, bond yields have already risen, as have inflation expectations. In the same way as interest rate markets move in anticipation of a likely RBA movement, the inflation markets move in anticipation of a movement in inflation data. But also like interest rate markets, inflation markets are not perfect and are prone to biases.
We can’t know whether current inflation expectations are correct until afterwards, of course, but we can check how the inflation markets performed during the outbreak of inflation in 2022. The short answer is that during the start of the increase in inflation in 2022, markets did not fully appreciate how high inflation was going to go and how long it was going to stay there. For bond investors who are using their portfolios for capital stability, even a single observation of markets underestimating future inflation is an interesting data point. You could have switched to inflation-linked assets well before the rise in actual inflation and received stronger returns than by staying in nominal assets.
The path to fighting inflation in portfolios
We think the market is under-pricing the likely path of inflation. In other words, buying inflation insurance in the form of inflation-linked bonds is currently quite cheap. Given the very real possibility of a sustained rise in inflation, now is an excellent time to purchase inflation protection.
One important consideration we wish to point out, however, is that inflation-linked bonds are still bonds. There are some very long inflation-linked bonds available (as much as 30 years). However, these very long bonds have so much duration risk that they are poor hedges against inflation in the short-term. Over the full 30-year term, these “linker bonds” perfectly hedge inflation, but over two or three years, the impact of CPI indexation is quite small, while the impact of changes in interest rates can be very large. That makes them inappropriate for investors who have a short or even medium-term investment horizon.
Many of the inflation-linked bonds in the market are deliberately owned by asset-liability matchers like life insurance companies. These companies deliberately want the duration risk because they are matching a liability set with incredibly long duration. They tend not to want to own the shorter inflation-linked bonds, which means there is scope to pick up shorter “linker bonds” at good prices.
Bonds which offer inflation protection
When we wrote our RISE strategy in January, we emphasised the need to prepare for the potential of higher interest rates and higher inflation driven by domestic developments. The war in the Middle East has strengthened many of the same themes. We believe the approaches outlined in RISE are now even more relevant given the increase in inflation risk driven by the war. The “I” in the RISE strategy was inflation protection, and investors would be wise to consider further inflation protection now.
The most obvious candidate is the Sydney Airport Nov-30. As an inflation-linked bond with only a 4.5-year maturity, it is very well suited to investors who are worried there might be a burst of inflation in the coming years. The Sydney Airport line is one of the few inflation-linked bonds issued by someone other than a government, which means clients receive a credit spread, too. At present, this bond is offering a yield of around CPI + 3.31%.
For those who want a little more safety, the Government inflation-linked bonds maturing in September 2030, November 2032, and August 2035 are also strong contenders. The Nov-32 is currently offering a CPI +1.94%, while the Aug-35 is CPI + 2.29%.
