Dealing with inflation on a fixed income

‘Thus, the rise in nominal yields was a result of higher inflation expectations, in anticipation of, and then in response to, the Fed’s QE3 announcement last month (inflation expectations are already pulling back). Consequently, Treasury returns have stalled in recent months, which we interpret as a signal that the underlying uptrend is no longer intact.

‘That said, in the short term, G7 government bonds should be well supported. Economic data will continue to be soft over the balance of the year, and inflation expectations are biased downward after their recent rise.

‘Looking out six to 12 months, we expect G7 government bond yields to gradually drift higher as global growth prospects improve. Upward pressure will principally come through higher real yields, as recession/deflation fears slowly are unwound.

‘The flip-side is that the Fed and other central banks are committed to keeping short-term interest rates low for an extended period, and would combat any material rise in longer-term yields unless it were driven by a marked improvement in the economic outlook.’

In contrast to Capital Economics, MRB has a medium-term, two-year treasury yield target of 2.5%, which would imply a 4% loss on current pricing. In terms of inflation protection, the company’s bullishness has led it into a high-risk, high-volatility strategic overweight recommendation on Spanish and Italian debt, which at a current trading range of near 6% it believes will only be consolidated as the European Central Bank delivers on its pledge to save the union.

The volatility of inflation expectations has been a key opportunity for Cheviot’s chief investment officer Alan McIntosh.

Having run an underweight position in fixed interest for almost all of the last few years and exiting his inflation-protected gilt holdings in 2011 on pricing concerns, McIntosh says the recent moderation in pricing is close to the point at which he could be tempted back into a significant allocation.

‘At the moment linkers look very attractive relative to regular gilts on a valuation basis,’ he says. ‘But their pricing will be changed by the [government’s proposed] change to RPI [from a CPI benchmark] and we need more visibility on how that will change how they are valued.’

His caution is echoed by Capital Economics, which has calculated the government’s planned shift in how inflation benchmarking is calculated will wipe more than 1% off long-term yields, with inflation-protected gilt holders the biggest prospective losers under the new methodology.

Reforming the picture