Inflation-linked bonds: more than just inflation

Why Inflation Linked Bonds remain relevant

In rising inflationary environments, it is quite natural to consider inflation-linked bonds and to appreciate what they can offer to a portfolio. As inflation-linked bonds total return is a function of inflation indexation and the change in real interest rates, when inflation expectations rise, inflation-linked bonds tend to outperform their nominal counterparts which has been the case in the post-COVID period.

However, even in a low inflation environment, inflation-linked bonds may improve the risk adjusted returns of a portfolio as they tend to not correlate with stocks or other fixed income assets. Therefore, in stable & low inflation environments, we would expect inflation-linked bonds to deliver a performance close to their nominal counterparts. This has been seen historically in low inflation environments such as before COVID.

Total and relative (breakeven) performance of inflation linked bonds universe

All maturities ~9y of duration and short duration ~3y.

Breakeven performance signals the outperformance (or underperformance) of inflation-linked bonds relative to a comparable nominal bonds’ universe.

How to make the most of ILBs

At the moment, with real interest rates still in restrictive territory and growth expected to be subdued, long duration positions remain attractive. However, as central banks begin to cut interest rates, the front end and the steepeners positions should begin to look more attractive. This need to adjust duration allocation in order to optimise returns, is seen in the charts above, reflecting how each segment of the curve (front end and long end) have performed in different inflationary environments. We believe this demonstrates that taking an active approach to an investor’s inflation portfolio may be help to achieve better risk-adjusted returns.

The history from the past decade offers evidence that diversification within an inflation-linked bond portfolio may help investments from either credit-related events like the Euro Area crisis in 2011 and 2012 or duration swings such as 2022/2023. Not only should an inflation-linked bond global approach offer a better risk/return profile thanks to its diversification benefits, but we believe that there are broader opportunities available within a global approach than that of a local focus.

A global approach will tend to favour relatively higher real interest rates and, as a consequence, may maximize investors’ income adjusted for inflation. As the chart below shows, real rates remain in positive territory. We do not, therefore, expect them to subtract income to the asset class, unlike the past 10 years.

Likewise, a flexible active strategy may also bring value to the table by leveraging on seasonal inflation swings. A flexible approach should be able to allocate assets where inflation accruals are the sharpest and potentially benefit from seasonal patterns or structurally higher inflation.

Although we face a disinflationary environment, inflation risks remain tilted to the upside, so in the medium term, inflation-linked bonds may still have a role in mitigating against this risk. They can also play a broader role in a portfolio, offering investors diversification and low correlation to other investments without necessarily taking on additional credit risk.