Interactive Investor

How bond funds are positioning for higher inflation

8th June 2021 09:11

Ceri Jones from interactive investor

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Inflation is the kiss of death for bonds because it erodes the real value of the interest they pay. Ceri Jones explains why strategic bond funds are best placed to cope.   

Inflation is stalking the markets, but while the near-term pick-up in price rises is a given, investors are struggling to gauge whether the release of spending from lockdowns and fiscal support will mean sustained inflation going forward.

With no handbook on how economies behave after a pandemic, there is a wide dispersion in views for the next year. What we do know is that UK households have saved £250 billion since the first lockdown began. Outgoing Bank of England economist Andrew Haldane believes they will spend much of that as facilities reopen, but judge for yourself the appetite for spending and socialising among your friends and family.

Consumer Prices Indices have hit post-pandemic highs in both the UK and the US. US CPI is particularly striking, rising 4.2% over the year ending in April, the biggest 12-month increase since the financial crisis in September 2008. While the figures reflect the collapse in prices last year - commodity prices tumbled and some oil contracts fell below zero – the US figure was higher than the 3.6% forecast by a Dow Jones survey of economists.

Why inflation is bad news for bonds

Inflation is the kiss of death for bonds because it erodes the real value of the interest they pay, and increases the likelihood that central banks will raise rates, which in turn make bonds look poor value in comparison. The recent CPI announcements spurred a resumption in the bond sell-off, which had been on pause for two months, pushing bond yields in the eurozone to their highest level for two years and US Treasuries 10-year bond to more than 1.6%.

While no one doubts that higher inflation is here, the crux is whether it will be a short-term bounce or more enduring. Ignore the US Federal Reserve, of course, which is keen to play down the current bout of price rises as a ‘transitory’ response, and indications suggest a long-term problem.

Commodity prices have soared, while there are supply chain problems everywhere. Consumers face shortages of goods, in everything from cars to Cadbury’s Flakes. While Brexit’s impact on restricting imports is a particular problem in the UK, the issue is global. The chip shortage has hampered car manufacture worldwide, while the price of used cars in the US has risen by 12% over a year, according to the research firm JD Power.

“High growth, transitory inflation and knowing that the Fed will come through and prioritise jobs over inflation – all that is already priced into the market,” says Mark Holman, chief executive officer of TwentyFour Asset Management.

He adds: “But more persistent is wage inflation. We have many underlying connotations of it – broken supply lines, shortage of chips. Always we hear production is not working somewhere, for example, a shortage of hauliers to transport goods across Europe. The whole world was shut down  and some production has not been easy to turn back on. We have talked to every single borrower in our bonds and asked them how they are going to cope with input price changes and they say with a good degree of confidence that they will pass it on to their customers in scheduled price rises.”

“A more fundamental issue even than Joe Biden’s monetary largesse, is that Labour markets are tightening up,” agrees James Foster, manager of Artemis Strategic Bond fund, pointing to the shrinking of the Chinese population that had provided a billion workers, the growing need for carers that takes productive people out of the job market, and the frosty relations between the US and China, the manufacturing base of the world.

Inflation-linked bonds may not be most effective inflation hedge

Many investors think the answer is inflation-linked bonds and have been pouring into bond funds that buy US Treasury Inflation-Protected Securities for 29 consecutive weeks, according to data provider EPFR. However, in an environment of rising inflation and negative, but rising, real yields, inflation-linked bonds may not be the most effective inflation hedge. To hold an index-linked bond is to take a position on real yields, which are currently very low. If central banks then proceed to reduce quantitative easing as the least painful way to reduce monetary stimulus, yields will rise further (causing bond prices to fall) and in this environment index-linked bonds will struggle.

Strategic bond funds are best placed to cope with higher inflation. Such funds can move their portfolios to where they see the greatest value, such as Artemis Strategic Bond Fund, Allianz Strategic Bond, Janus Henderson Strategic Bond, Jupiter Strategic Bond (a member of interactive investor’s Super 60 list) and TwentyFour AM Dynamic Bond. Other bonds funds are restricted to investing in a certain type of bond (such as investment-grade bond funds) or country (such as UK government bond funds).

The question for many investors, however, is whether it is worth holding bonds because rising inflation and higher yields creates the prospect for capital losses, yet on the other hand, bonds hold their value in a shock.

Why bond investors should not be alarmed

“Despite central banks’ tapering discussions, we believe that there is no need for investors to be alarmed provided that forward guidance remains clear and credible,” argues Steve Bramley, fixed income investment director at Fidelity International. “Year-to-date inflows into global stocks have been roughly two-and-a-half times the inflows into global bonds, heightening the risk of some disappointment in stocks further down the line… Should prospective bond investors proceed with caution? We think not. Tapering, like taxes, is inevitable, and the upward move in bond yields and forward expectations suggests markets may have already moved in anticipation.”

Inflation is also hurting equities, of course, particularly growth stocks such as tech, because they are valued on their earnings potential in future, which is calculated by discounting back to current day rates and high inflation implies a rise in rates. An inflationary environment favours the ongoing rotation to value stocks and sectors that have a strong correlation with price rises, such as energy, basic materials and financials.

“A central view of the Jupiter Independent Funds Team, Merlin, is that we are in a new economic cycle and so we have allocated capital away from bonds to equities to take advantage of the economic growth and earnings potential as the world opens up,” says David Lewis, co-head of strategy of Jupiter Independent Funds team. “Despite this, many of our portfolios continue to have significant exposure to bond funds in strategies we believe can act as good diversifier, can perform defensively in times of trouble and produce income and the potential for capital returns.”

He adds: “Currently, a number of our bond fund managers are seeing opportunities in pockets of the high yield credit universe, where typically short duration bonds can be found with attractive yields, backed by solid balance sheets and cash flows. These bonds also tend to be less sensitive to moves in interest rates, inflation and sovereign bonds as their drivers are more stock specific.”

Holman agrees: “Conditions for credit are terrific going forward,” he says. “Upgrades are outpacing downgrades by two to one.  The default rate has collapsed. 95% of companies beat earnings expectations in the last results season.”

Holman particularly likes banks, which are going through a re-rating and is buying CoCo bonds (contingent convertibles) in European banks that convert into equity if a pre-specified trigger event occurs, and floating rate Collateralised Loan Obligations (CLOs) that benefit from the drop in defaults. Artemis Strategic Bond fund has also increased its exposure to high-yield bonds (44%) and to hybrid bonds (17%), which combine debt and equity characteristics.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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