Can bonds protect investors from inflation risk?

By Simon Matthews, Portfolio Manager, NB Global Monthly Income Fund

With the latest inflation data just released, showing the UK inflation rate (CPI) is at an almost 30-year high of 5.4%, pressure will be felt across the country and investors will be looking for a way to help tackle these inflation rises. We believe there are types of bonds that can help investors.

With cash earning zero and inflation over 5%, purchasing power has been eroded. The longer it takes to get paid back when purchasing power is eroding is reflected in the price of ‘fixed’ coupon bonds with longer durations. For example, price goes down because the value of those future cash flows is worth less today as a result of future expected declining purchasing power due to rising inflation expectations. Central banks are embarking on a rate hiking cycle to combat higher inflation currently.

The types of bonds or fixed income asset classes that generally do well in this type of environment are shorter duration and/or floating rate bonds issued by corporates which provide to investors a spread over risk-free base rates, particularly when issuer fundamentals (i.e., their ability to pay the coupon and return principal) are solid and improving. Another way to put it is that yields are more than compensating for the benign default risk. This is typically the case at earlier parts of the credit cycle, which is where we are currently.

Default rates on higher yielding, lower duration bonds and the even lower duration, floating rate loans (below-investment grade credit i.e. high yield bonds and leveraged loans) are close to all-time lows, while the yields remain very attractive (in the 4.0% – 5.5% range). The floating rate nature of senior floating rate loans offers a low cost ‘hedge’ against inflation and have also tended to outperform the overall bond market in both flat and rising interest rate environments. Further, the senior secured nature of the asset class provides an additional assurance of getting paid back before others.

But what will happen if there are even more base rate rises? Typically, what we see occurring through history in this type of environment can be broadly described as follows:

When interest rates are rising, an economy is doing well which leads to a growth in earnings. When you add in an improvement in company fundamentals, that leads to a decrease in corporate credit risk resulting in strong returns.

We believe the positive impact on credit spreads (which is the aforementioned decrease in corporate credit risk) more than outweighs the negative impact of risk-free rates rising.

While headline figures and economic forecasts for the year ahead still look uncertain, there are plenty of opportunities for investors to shield themselves from inflation risk.

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