Key Takeaways
- Inflation has risen above central banks’ targets in many countries due to energy prices.
- European inflation-linked bonds have performed well since the start of the year, bucking the trend seen in most traditional bond markets.
- Inflation-linked bonds may benefit when inflation remains elevated but economic growth weakens.
Inflation-linked bonds have outperformed this year as an energy supply shock triggered a rebound in consumer prices worldwide. Markets may be underestimating the risk of a renewed inflation shock, warranting a closer look at this asset class.
“There is certainly a case to be made for investors to hold inflation-linked bonds today. Inflation has been above target across many developed countries around the globe, particularly across Europe and in the United States”, says Dominic Pappalardo, chief multi-asset strategist at Morningstar.
The recent rise in energy and oil prices caused by the war in the Middle East pushed inflation in the eurozone to 3% in April, above the European Central Bank’s 2% target, and is driving up production costs for nearly all goods and services for consumers. In the United States, inflation rose at an annual rate of 3.8% in April, driven primarily by energy costs.
What Are Inflation-Linked Bonds?
Inflation-linked bonds are securities tied to a price index designed to protect the investment against inflation. Issued primarily by sovereign governments, they provide for an adjustment of the principal and coupons based on changes in the price index. Essentially, they serve as a form of insurance against the risk that inflation will erode the future value of the portfolio. However, if inflation falls, they may generate lower returns than traditional bonds. Also, the insurance comes at a cost itself, although the benefits may outweigh that cost in certain market conditions.
Inflation expectations are reflected in the bond market through the breakeven rates of inflation-linked bonds—that is, the level of inflation that must occur before the bond’s inflation-protection feature kicks in, allowing these bonds to outperform traditional bonds.
Investors Tend to Underestimate the Risk of Higher Inflation
“European inflation-linked bonds have posted positive returns since the start of the year, bucking the trend seen in most traditional bond markets. This trend confirms the primary function of this asset class: To offer effective protection when exogenous inflationary shocks—such as geopolitical tensions linked to the conflict with Iran—arise unexpectedly,” says Jack Kelly, fixed-income portfolio manager at Fineco Asset Management, who adds that markets systematically tend to underestimate inflation risk.
Several experts interviewed by Morningstar agree that this risk is not properly priced in by the markets. The breakeven rates on 10-year inflation-linked bonds are lower than current inflation rates in both the United States and many European countries. In Italy, they range between 2.45% and 2.6%, in Germany around 2.4%, and in France at 2.3%.
This phenomenon indicates two things. “First, investors expect current high inflation rates to be temporary and to decline over the life of the 10-year inflation-indexed bonds,” Pappalardo of Morningstar explains. “Second, it also means that the price of the insurance policy is relatively attractive, since there is a margin of safety in which inflation could decline marginally over the life of the bonds and these securities could still outperform nominal government bonds, which do not offer the same protection against inflation.”
The Rise in Inflation May Not Be Temporary
Before the war in Iran began, inflation expectations had fallen to around 1.75% in European one-year bonds, indicating that markets expected consumer price inflation to fall below the ECB’s 2% target.
“At those levels, the risk-return profile appeared highly asymmetric,” Kelly says. This means there was limited room for further downward revisions to expectations, but significant upside potential in the event of exogenous shocks.
“The subsequent repricing highlighted how complacent the market had become,” adds Kelly, who believes that inflationary pressures will persist in the medium term, not only for reasons related to energy costs, but also due to growing infrastructure investments for data centers underpinning artificial intelligence.
How Much of Your Portfolio Should Be Allocated to Inflation-Linked Bonds?
Since inflation poses a risk to fixed-income investors by eroding the principal value of their investments, inflation-linked securities can help mitigate this portfolio risk.
“Within a diversified bond portfolio, we believe an allocation of approximately 20% to inflation-linked instruments is appropriate under current market conditions: a level sufficient to provide significant protection against the risk of persistent inflation, without compromising the defensive and income-generating characteristics of the bond market as a whole,” says Kelly.
Where Are Bond Fund Managers Investing as Inflation Rises?
With inflation remaining one of the main risks to global economies, portfolio managers are seeking protection in US Treasury Inflation-Protected Securities (TIPS) as well as other inflation-linked securities.
“In the United States, TIPS offer attractive protection against some of the uncertainties surrounding the energy sector stemming from the conflict in the Middle East. Real yields are at their highest levels in the past decade and do not reflect the persistence and upside risks we see for inflation. We are also finding value in US breakevens, a market indicator of expected inflation, especially at the longer end of the curve,” says Flavio Carpenzano, asset class lead for fixed income in Europe and Asia at Capital Group.
Marc Seidner, Pimco’s chief investment officer for non-traditional strategies, believes that US inflation-linked bonds can be an “effective tool” for protecting against inflation, but notes that when real yields—that is, yields adjusted for inflation—rise, prices of longer-term bonds may still decline due to interest rate risk, even as inflation rises.
For this reason, he recommends considering “approaches that prioritize exposure to short-term inflation-linked bonds and more targeted instruments, such as inflation swaps,” as they can enhance a portfolio’s inflation-hedging capabilities. “This allows for better isolation of inflation mitigation while managing sensitivity to changes in yields.”
Frank Lipowski, head of fixed income at Flossbach von Storch, also looks beyond the United States: “We haven’t invested solely in TIPS, but also in eurozone [inflation-linked bonds]. Inflation-protected bonds continue to account for over 20% of our portfolio. The future, however, is uncertain: Geopolitics, inflation, and central banks are difficult to predict. We therefore maintain a diversified basket of inflation-indexed government bonds in our portfolio, but without putting all our eggs in one basket.”
