Joanne Ellul asks how index-linked bonds will fare if inflation figures take a tumble
Inflation-linked bonds are looking attractive to investors but are they a good long- term investment?
The UK consumer price index reached 5.2 per cent in September, according to the Office for National Statistics.
Index-linked bonds may be performing strongly in this environment but how they will fare if and when inflation drops?
Kames Capital co-head of fixed income Stephen Jones, who runs the £239.5m Kames inflation-linked fund, has a multi-asset approach, which means the fund can invest in other asset classes such as equities and commodities.
According to Jones, this flexibility means if infla-tion falls, the fund can diversify to protect against losses. He says: “People think index-linked gilts are expensive but they do still offer that ultimate safe-haven protection against infla-tion. They are a sensible core in the fund. In a way, we acknowledge the exp-ense of the core by taking cash in the fund and putt-ing it into other assets.”
Standard Life fund manager Jonathan Gibbs, who runs the £814.1m Standard Life Investment global index-linked bond, also uses asset classes outside of bonds to generate returns.
He believes it is not the current rate of inflation that drives valuation rates in inflation-linked bonds but the expectation of future inflation. He says: “When inflation falls sharply you do lose a bit in terms of future inflation expectations but it is more about long-term inflation rate expectations.
“The risk of high inflation has never been greater and I do not think the market is pricing in that risk yet. Essentially, investors are getting inflation insurance cheap.”
Bestinvest senior analyst Ben Seager-Scott says inflation-linked bonds can be good long-term investments even if inflation is falling, as their attractiveness depends on break- even inflation.
Break-even inflation is the difference between the nominal yield on a fixed-rate investment and the real yield on an inflation-linked investment of similar maturity and credit quality.
If inflation averages more than the break- even point, an inflation-linked investment will outperform the fixed rate. Conversely, if inflation averages below the break-even point, an inflation- linked investment will underperform.
Seager-Scott says: “Inflation-linked bond funds can be good long-term investments even if inflation is falling. If the inflation rate is above that break-even point then, over the medium to long-term, investors will still be making returns on it.”
Seager-Scott says inflation-linked bonds have become more popular with investors who are worried about inflation but warns that some products do not have caps that prevent the coupon going down if there is deflation.
He says: “This would be an issue for investors if the UK entered a deflationary environment but we have not had serious deflation here for a long time and I think it is unlikely, given the Bank of England hates deflation.”
Hargreaves Lansdown head of research Mark Dampier says: “Most inflation-linked bonds and particularly index-linked bonds are expensive and they are mostly long-duration assets. If interest rates go up, they get canned.
“There is currently more short-term opportunity in inflation-linked bonds than long-term opportunity, as inflation looks underpriced in the short term. Given the lack of growth, many would argue that inflation will fall rapidly next year - at least that is what Bank of England is hoping.”