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Duration risk is sting in the tail of inflation-linked bonds

Duration risk is sting in the tail of inflation-linked bonds

Investors seeking safety in inflation-linked bonds must beware being hit with capital losses from interest rate rises if they fail to hold the bonds until maturity. Fund managers Paul Rayner (pictured), David Hooker and Marion Le Morhedec highlight the pros and cons.

Investors looking to inflation-linked bonds for protection need to bear in mind they are exposed to interest rate risk, and could be left unprotected against falls in the price of the bond if rates rise. Rising inflation typically is accompanied by interest rate rises.

Inflation-linked bonds are inadequate as protection against rising rates if not held until maturity, according to Paul Rayner, manager of the £417 million Royal London Index Linked Fund. Investors not holding the bonds to maturity are exposed to duration risk: a measure of the sensitivity of the price of a bond, or portfolio of bonds, to changes in interest rates.

Suitability check

Rayner believes that, because of their long average duration, inflation-linked bond funds are more suitable for pension funds and insurance companies with multi-decade liabilities, rather than retail investors.

‘I talked to a client some years ago who had a really strong view that inflation was going to be high and wanted to buy my fund. It’s a bit counterintuitive but I said it was probably not the best idea,’ he said.

‘We really stress this when we talk to investors in the fund. Most inflation products out there are not inflation-protected bond funds but real yield funds. With 19 years of duration, the biggest driver is what happens to real yield, not inflation.’

Inflation-linked bonds typically link their coupon payment and/or principal repayment to an inflation index. In the UK, the retail price index (RPI) is the most common, as inflation-linked bonds came to market in the early 1980s when RPI was the official measure of inflation. In the US, most inflation-linked bonds are linked to the consumer price index (CPI), the official inflation benchmark in the UK since 1997.

However, the protection against inflation is only partial, according to Rayner. ‘If inflation gets out of control, the Bank of England would have to react by pushing base rates up sooner and faster, meaning real yields would have to go up more. Because you are in the longest-dated bonds, the real yield move would have offset any protection you had from inflation. You would actually lose money,’ he said.

Duration and deviation

Rayner’s fund has an average duration of 18.4 years, and is only allowed to deviate by two years from the duration of the FTSE A Index Linked Gilt All Stocks benchmark, which currently has a duration of 18.9 years.

‘We are very honest with our investors and say that anyone who wants to protect themselves against inflation needs to buy an inflation-linked fund with a shorter duration,’ said Rayner.

He said Royal London Asset Management was in the process of launching a short-dated version of the fund, with an average duration of about five years, to satisfy this demand.

The fund has suffered outflows in the past 12 months. ‘The fund had probably around £540 million in assets early last year, but we had two large retail fund of funds investors,’ said Rayner. ‘We told them this was not the right product for them to invest in at the moment and they withdrew.

‘We hope they are going to notice the short-dated fund we are planning to launch. I have learned from my career that honesty pays.’

The Royal London Index Linked Fund has returned 24.4% over the past three years, narrowly ahead of the 23.3% of the FTSE A Index Linked British Government All Stocks index over the same period.

Reap the rewards

Citywire + rated David Hooker, manager of the £339 millionInsight Investment UK Index Linked Bond Fund, believes inflation-linked funds offer adequate protection against rising prices.

‘If you are comparing yourself to a nominal bond fund, then you most definitely are protected against inflation because inflation-linked bonds have a direct link to inflation,’ he said.

But he also highlighted investors’ need to hold inflation-linked bonds to maturity in order to reap the benefits from the inflation linkage.

‘If you buy a bond and hold it to maturity, you will get a guaranteed return linked to inflation. But there is a market risk to holding any bond fund or any inflation-linked asset,’ he said.

Hooker argued that, despite recently falling inflation with CPI at 1.9%, now is the time to seek inflation protection. ‘Everybody is focused on the short term. The good news is that the price of inflation-linked bonds has fallen. We believe this creates opportunities,’ he said.

‘Think of it as house insurance: do you want to buy house insurance when your house is fine or do you want to buy it when it’s on fire?’

Although inflation has remained subdued for some time, Hooker said the future was uncertain, pointing to unknown repercussions from the Western world’s ultra-loose monetary policy since the onset of the financial crisis in 2008.

‘Inflation seems to be benign over the short term, certainly for the rest of this year and into next year. But over the longer term, two years and out, we have concerns. We don’t know what impact the current policy mix is going to have over the next few years. To be more precise, we don’t know how the unconventional monetary policy put in place by central banks will impact economies over the next few years. One possible outcome is higher inflation,’ he said.

‘Governments, not only in the UK but globally, have taken on a lot of debt to deal with the financial crisis. Although the pace of accumulation has slowed, the overall level of debt to GDP is still high. One way out of that is a reflation policy. That is what we think governments and central banks are pursuing currently.’

Reflation game

While the US Federal Reserve announced the start of the tapering of its asset-buying programme in December, Hooker said monetary policy remained very loose.

‘They are still doing QE [quantitative easing] in the US. They are just slowing the rate of purchases; they are not shrinking their balance sheet. While it could come to an end by the end of the year, the stock will still remain in place, and the ultra-low interest rates will remain in place. And the budget deficits the Western world has been running will still remain in place,’ he said.

‘Whichever level you are looking at, fiscal, monetary or indeed unconventional polices like QE, governments and central banks remain extremely accommodative. For example, in the UK we have the Right to Buy scheme as an example of a reflationary policy,’ said Hooker.

‘Governments are trying to grow their way out of the situation. This may create inflation. If you look at the peripheral countries in the eurozone, they are solving their sovereign debt problems through deflation. In the UK, higher inflation is a risk, which may or may not materialise. We think the balance of probability is tilted to the upside.’

Over the past three years, the Insight Investment UK Index Linked Bond Fund has returned 26.9%, slightly ahead of the 24.4% of the FTSE A Index Linked British Government Over Five Years index.

Climate control

Citywire + rated Marion Le Morhedec (pictured), manager of the €2 billion (£1.7 billion) AXA WF Global Inflation Bonds fund, agreed that the best time to invest in inflation-linked bonds is when inflation is falling. ‘The best climate to invest in the asset class is when inflation is decelerating and low, which is the case now,’ she said.

‘This is because the premiums embedded in the inflation-linked bonds are cheap. It is a good time to protect portfolios when inflation is not yet a worry.’

Le Morhedec, who is based in Paris, said disinflation rather than inflation was the problem in the eurozone. ‘That is something the European Central Bank (ECB) might have to look at,’ she said.

When the ECB met on 6 March, it decided to hold its benchmark interest rate at a record low of 0.25%, and not resort to unconventional monetary policy, such as asset purchases, despite downgrading its inflation estimate for the eurozone to 1% from 1.1% for 2014.

‘For the strategy to perform, you need to add expectations that inflation will rise in the medium to long term. If you think we are entering a deflationary spiral, the fund is not going to perform. So while it is good to buy when inflation is low, you need to expect that it will pick up,’ said Le Morhedec.

Nevertheless, Le Morhedec is struggling to see inflationary pressures. ‘Over the past years, inflationary pressures have been coming mostly from currency and commodity effects. This is something that is probably going to be much softer for the years to come,’ she said.

‘In the past, inflationary shocks have come from oil price increases. But now, with shale gas development, such pressures are vanishing.’

Time sensitive

Echoing Rayner, Le Morhedec warned inflation-linked bonds were sensitive to interest rate hikes.

‘When you invest in this fund, it comes with more than 11 years of duration. You are thus extremely sensitive to movements in interest rates. The idea is to protect the strategy against inflation, but it will only work if you hold it for a very long time,’ she said.

‘We can’t go shorter than 11 years on the global fund because we can’t deviate more than two years from the duration of the index. It’s a more traditional fund, with many insurance companies and pension funds among the investors, and they need long-term investment guidelines because they have long-dated liabilities,’ she said.

Le Morhedec said AXA launched a similar fund in 2012, but with a duration of 4.86 years: the $236 million (£114 million) AXA WF Universal Inflation Bonds fund, which she manages with Jonathan Baltora.

The AXA WF Global Inflation Bonds fund has returned 15.3% over the past three years, ahead of the Barclays Global Inflation Linked index at 10.9%.

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