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Income: Are inflation-linked bonds overinflated?

Income: Are inflation-linked bonds overinflated?

Inflation-linked bonds are useful tools for investors but fund managers question whether they are worth buying in the current environment.

Rakesh Girdharlal, liability driven investment portfolio manager at Aviva Investors, believes they are ideal for investors looking to preserve the inflation link to cashflows.

‘Buying them protects against high inflation,’ he said. ‘They are often used by pension and insurance companies to match inflation-linked liabilities.’

Girdharlal said government-issued inflation-linked gilts are very liquid, so they can be bought and sold to meet an investor’s preference. But he warned there would be a limited supply over the next quarter, which means prices are expected to increase towards the end of the year.

‘The best value for money is currently offered by those with maturities of more than 30 years,’ he added.

Bad timing

Adrian Lowcock, investment manager at Architas, is unsure if now is the right time to buy. ‘Last year, inflation-linked bonds rallied on the back of the devaluation of the pound as investors expected a rise in inflation,’ he said. ‘So far we haven’t seen any indications of further inflation.’

In fact, the opposite was potentially true. ‘Inflation is close to peaking in the UK and there are plenty of deflationary pressures to be concerned about. This means inflation-linked bonds look a bit expensive,’ he said.

Separately, Lowcock pointed out inflation-linked corporate bonds have been scarce in recent years. ‘Demand for low risk income has been high, so companies haven’t needed to sweeten the deal by offering inflation protection,’ he explained.

Pros and cons

Bryn Jones, Citywire + rated manager of the Rathbone Strategic Bond fund, believes there are benefits and negatives of buying such products. ‘One benefit of buying index-linked gilts is their very high credit quality as it’s unlikely you will see them default,’ he said.

On the flipside, they do not yield much. ‘Real yields are negative, so you actually need a certain amount of inflation just to be net even,’ he said. ‘They also tend to be very long duration so are sensitive to changes in interest rates.’

Jones also pointed out that, while corporate index-linked bonds may have more attractive yields, they are subject to income tax on the inflation uplift. ‘The after-tax yields can often be less than that of the index-linked gilt,’ he added. ‘They also tend to be quite illiquid.’

The end of inflation?

Looking ahead, Jones believes inflation-linked products will continue to play a role in portfolios. But he argues central bankers are struggling to push inflation much higher.

‘There are big global themes that may cause inflation in the future to be a lot lower,’ he said. ‘These include demographic trends of people living longer and you may argue the rise of the machines will create deflationary forces.’

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