Is it bad for bonds?
So what does this mean for Bonds, and is there an opportunity for investors?
Eve explained, “It’s worth acknowledging that people traditionally see inflation as bad news for bonds. You can see why, because it erodes the real value of the payments you receive.”
But, he explains, there are not only various ways investors can protect themselves from the worst effects of inflation but that fixed-income investors can take advantage of the trends discussed above.
Taking a big-picture view, Eve comments “If we see relatively steady inflation that’s going hand in hand with real economic growth that can be supportive for risk assets, and that could be supportive for credit. You see a very good correlation between credit performance and GDP over time when investing in in corporate bonds, for example.”
For Eve, the risk is having too much interest rate risk or duration in your portfolio, as interest rates tend to rise with inflation.
With that in mind, one option is to invest in shortdated corporate bonds or another is to hedge away the duration in corporate bonds using bonds futures.
Floating rate notes are another opportunity he sees. These are generally issued by companies, but have coupons that float in line with interest rates, usually resetting every quarter.
Eve explained that in such cases, “Your interest rate duration is limited and it is considerably lower than buying a non-floating rate bond. So there’s another way to take credit exposure, which you might expect to do well, if we do see a good recovery continue.”
Looking at linkers
Inflation-linked bonds are another choice for investors. However, they often tend to have a lot of interest rate risk embedded in them because they’re generally reasonably long dated.
Eve clarified, “If you look at a passive allocation of inflation-linked bonds over time, they tend not to be a very good inflation hedge.” He continued, “What we do in a number of portfolios is take exposure to inflation linked bonds, but then hedge away the duration. And so you’re left with the purer inflation exposure.”
This approach can limit the interest rate risk, but will leave exposure to that inflation-linked part.
A question of currency
For more flexible bond portfolios that can invest in currencies, there are yet more opportunities.
An investor can increase exposure to currencies that tend to have a high correlation with global trade and with inflation. Eve highlighted the Canadian dollar as a good example that tends to be correlated to North American inflation. Also, that the Australian dollar correlates well with China trade, because of their trade links with China and Asia.
Commodity and oil exporter countries’ currencies tend to be quite well correlated with oil price and commodity prices and inflation. Eve noted a good example of the Norwegian Krone, and the Russian Ruble.
Eve concluded by stressing the essential message of what he’d discussed, namely that to exploit these developing trends in fixed income, it’s crucial to take an active approach.
And how does he sum that up? We’ll leave the last words to Andrew Eve as he comments “A passive allocation to bonds may not be the most sensible thing in this type of inflationary environment: an active approach, I think, can allow investors not only to protect themselves but even to take advantage of some of these trends.”
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About Andrew Eve
Andrew Eve is an investment specialist in M&G Investments’ fixed income team with a focus on global macro strategy. He edits and contributes to the team’s Bond Vigilantes blog. Andrew joined M&G in 2017, having gained a four-year Master’s degree in Chemistry from the University of Oxford. He also holds the Investment Management Certificate and has passed level 1 of the CFA Program.
The views expressed here should not be taken as a recommendation, advice or forecast.
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