While the sudden surge in inflation might be cause for alarm for investors, Colin Finlayson, co-manager of the Aegon Strategic Bond Fund, believes the spike will be transitory, with inflation returning to more normal levels over the medium and longer term.
“In the short term, as we move through 2021 and head into 2022, there is the potential for inflation to be slightly stickier at higher levels, which many have expected to exceed the target levels of inflation. The consensus idea is inflation will spike, and then go back down to a normal level in an orderly fashion. We feel it won’t be as straightforward as that.
“But the longer-term disinflationary sources that have been around for much of the last decade will ultimately re-exert themselves, and will move inflation back down to more normal levels in the medium and longer term. As a result, this longer-term threat of inflation isn’t something we would be overly concerned about.”
As inflation rises in the short term and central banks have not yet met the call to action, investors are faced with the dilemma of where to go with their fixed income holdings.
“Investors are typically faced with two fears in this environment. One being what high inflation will do to the value of their assets. Higher inflation tends to lead to higher yields, and consequently higher levels of interest rates. As a result, even the natural, nominal value of their assets can fall.
“Secondly, we have the concern of the impact of higher inflation on the real value of their assets. This is an important concern but not one that is immediately observable and can happen slowly in the background. Most investors in this environment tend to focus more on the price of the bonds and how they change. Instead, they should pay attention to how the central banks react to higher inflation.”
To avoid the threat of increased interest rate risk, Finlayson suggests investors take a less traditional and more flexible approach to fixed income investing.
“In this inflationary environment, deciding where to invest within the bond market, the individual bonds, and the sectors is crucially important. As a fixed income investor, you need to find ways or vehicles to invest in which can offset some of the damage that can occur. One such area is high yield.
“We tend to see the high yield market perform better in this inflationary backdrop than either investment grade corporate bonds or government bonds. This is due to the high yield market and the companies within in being less sensitive to changes in interest rates.
“In addition, the business models of high yield companies are also geared towards doing well in periods of economic recovery – which tends to drive inflation – creating a good environment for a profitability.
“You are of course taking on more credit risk by investing in high yield. However, we view this as a better place to offset some of the other losses you might expect from the other parts of the fixed income market.
“This isn’t the time to completely abandon ship from all of your fixed income investments, but instead investors should direct it towards the parts of the markets than can best deal with the rising inflationary backdrop we will inevitably face in the short-term.”