Standard Life Investments

Published Article

Investment Week – Bull Bear – Inflation Linked Bonds


 

Summer has brought relative stability to markets after a febrile first half of 2013. Attention is largely focused on central banks, with forensic examinations of the language of policy makers, as we try to determine the pace of easing of stimulus to economies.

The key word in the previous sentence is “easing”. Stimulus, in terms of super low interest rates, is not being withdrawn anywhere, anytime soon. It is just that some of the more extreme measures which are morphing into new approaches to policy.

Initial market reactions to the merest hint of taking away the stimulus drug were negative across both bonds and equities, and perhaps one of the most remarkable points was that real yield markets took it worse than nominal bonds. Was the market telling us that without on-going quantitative easing, inflation would drop sharply despite near zero rates? We would normally expect inflation linked bond yields to move more slowly than nominals as they rise, but their normal protection has not been in evidence this year.

Real yields have risen across all the major markets this year, and while we would struggle to call them cheap, they are at least positive further down the curve. Yet implied inflation expectations have of course fallen due to the recent under-performance of linkers. Do they now represent value in the bond portfolio?

In the UK, ten year expectations for RPI are just below 3%, which looks low when we consider the structural differences between CPI and RPI, especially when we factor in a widening gap when mortgage rates, which are excluded from CPI, rise, which they will of course do, one day.

For the US, investors can buy inflation protection at around 2.1%, below the 2.4% average for the last ten years of inflation, and way below the 2.9% of the last thirty years. Does the market really expect another decade of very low inflation, despite the huge stimulus still being applied to the economy?

Japanese expectations jumped sharply after PM Abe fired his first two policy arrows, and although the initial euphoria has faded, the market still seems to have faith that the new government will deliver growth, and inflation, albeit a little, ending the “lost generation.”

Finally Europe is still struggling with a euro crisis, and inflation seems destined to remain low here, but a long term inflation insurance policy may be worth considering, against the event of future meltdown.

Inflation linked bonds then offer cheap inflation protection, in general, and a global portfolio will deliver steadier returns. Yet it is of course as a diversifier that inflation linked bonds offer their best, as they are likely over the cycle to be poorly correlated with other real assets, thereby enhancing the returns, and reducing the volatility of the wider portfolio.

BULL POINTS

Inflation expectations appear low in many markets, making linkers look attractive relative to nominal bonds

Real yields are still low, but inflation linked bonds are likely to re-establish their low to negative correlations with risk assets, making them great diversifiers

BEAR POINTS

If stimulus is withdrawn too quickly, inflation expectations may drop further

Recent price action suggests that a reasonable risk premium should be demanded by investors

Jonathan Gibbs, Investment Director, Standard Life