Inflation-linked bonds attractive despite uncertain outlook

Added 11th August 2017

Despite a murkier outlook for global inflation, there could be “positive surprises” ahead which make inflation-linked bonds an attractive diversifier, Fidelity International says.

Inflation-linked bonds attractive despite uncertain outlook

Inflation-linked bonds have come under pressure recently as inflation expectations have come down, but Andrea Iannelli, fixed income investment director at Fidelity International, believes there are risks on the horizon that could cause inflation to spike, making the asset class appealing as a hedge against nominal duration.

This comes after other asset managers have warned that bond investors, particularly those in passive vehicles, are too exposed to duration risk without realising it.

Iannelli said with the uncertain outlook for global inflation, as well as the lack of wage growth and tighter monetary policy in developed markets, the recent underperformance has created value in some areas of the asset class.

“This is particularly the case in US inflation-linked bonds, where we have seen a sharp repricing of the ‘Trump trade’ as the challenges of getting reforms passed in Congress became apparent,” he said.

Iannelli observed 10-year US breakevens – the difference between the yield of a nominal bond and the real yield on an inflation-linked bond of the same maturity – are appealing at current levels, having tightened from more than 2% in January to 1.77% currently.

“Investors no longer expect any meaningful reform to be approved in the US, and any step forward by Congress on taxes or investments would be a positive surprise,” he added.

“By the same token, protectionist policies that could cause a one-off spike in US inflation could easily come back on the agenda.

“Lastly, the recent bout of US dollar weakness may translate into higher goods prices in 2018, supporting inflation expectations and US breakevens.”

Darren Bustin, co-manager of the Royal London Absolute Return Government Bond Fund, said despite caution from the Federal Reserve, inflation could return to the US economy, especially if it sees a pick-up in wage growth.

However, he said other markets look less rosy for global inflation-linked bonds.

Bustin said: “In the UK, inflation may have peaked in the near term, while in Europe breakevens are beginning to look relatively expensive.

“Index-linked gilts have already sold off to a degree and the peak in inflation could actually be an opportunity to sell these bonds, should breakevens rise.”

Meanwhile, Bustin said a strengthening pound and weaker data offer some notable downsides to the UK’s inflationary environment.

“Supply and demand factors also mean that the market for inflation-linked bonds assets is not a one-size-fits-all game,” he added. “While the UK has plenty of structural demand thanks to defined benefit pension schemes seeking to hedge their liabilities, the US market is far more closely rigged towards supply side issuance than market demand.”

 

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