Inflation-linked bonds: protection in a more volatile inflation world

Talking Heads with Elida Rhenals

Andy Craig: Hello and welcome to this week’s BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing inflation-linked bonds and the role they can play for investors in view of the current macroeconomic environment and outlook. I’m Andy Craig, Co-head of the Investment Insights Centre. I’m joined today by Elida Rhenals, Co-head of Inflation and a Senior Portfolio Manager within the Global Fixed Income team. Welcome, Elida, and thank you for joining me today.

Elida Rhenals: Hi, thank you for having me.

AC: Let’s start by talking about the macroeconomic picture – on why, in our view, this is an environment which is favourable for inflation-linked bonds. Inflation has reappeared on investors’ radars. We have the situation in the Middle east, the crucial choke points for the delivery of petrol, but there’s still a lot of uncertainty. How do you see the current environment for inflation? And why do you think investors should consider inflation-linked bonds in this context? Isn’t it getting a bit late for the trade into inflation-linked bonds? We’ve been here for some time now.

ER: Inflation has clearly come back into investors’ radar but I would argue that the story goes beyond the latest energy shock. For a couple of years now, markets have been debating whether inflation was just a temporary consequence of the pandemic and the subsequent supply chain disruptions, or whether we have moved into a structurally more volatile inflation environment.

Our view has consistently been closer to the second option, and what has happened recently is a good illustration of why. The disruption in the Strait of Hormuz has once again shown how quickly an external shock can change [the] inflation outlook. Energy prices moved sharply higher and central banks suddenly had to reassess a policy path that at the beginning of the year looked much more straightforward.

The lesson for investors is not necessarily that inflation will remain permanently high, it’s that the distribution of inflation outcomes has become much wider; volatility is higher.

That distinction is very important, in our view. We have moved away from the environment we experienced during the decade before the pandemic when inflation was persistently below target and investors could almost take price stability for granted.

Today there are several forces that can generate more inflation volatility – geopolitics, energy security, changing supply chains, climate-related investment, fiscal policy and of course significant infrastructure and AI related investment.

So, late or not to invest in inflation in bonds? I would say this is the wrong way to frame the question. Inflation in bonds should only be considered when you expect the next inflation print to surprise to the upside. They are an asset class that allows investors to build inflation protection into a fixed income or multi asset allocation.

The other important point today is valuation. Real yields are significantly more attractive than they were for much of the last decade, so investors are no longer necessarily sacrificing yield to obtain inflation. You can earn a positive real yield while retaining that protection if inflation turns out to be higher than expected.

And that creates a much more interesting starting point to go into the asset class.

AC: You’ve mentioned real yields and that brings us into the functioning of inflation-linked bonds. Can you talk us through how inflation-linked bonds work? They’re obviously very different from nominal bonds. They provide inflation protection. How do they actually function?

ER: The first thing to clarify is a very common misconception. Inflation in bonds do[es] not simply go up whenever inflation goes up. At their core, they are still bonds. The difference is that their cash flows are linked to an inflation index. This means the principal or the coupons are adjusted according to realised inflation. That’s what we call inflation accrual. So, over the life of the bond, the investor receives compensation for the inflation that actually occurs. But the market price is also driven by interest rates, just like any other bond.

A useful way to understand the market is to split a nominal government bond yield in[to] two components – a real yield and expected inflation. That’s what we call breakeven inflation. If you compare a nominal government bond with an inflationary bond of similar maturity, the difference between the two yields give you an approximation of the inflation rate that the market is pricing over that period.

That means there are really two engines of performance.

The first is the real yield component. If these real yields fall, the price of an inflation bond rises like any other bond. If [the] real yield rises, its price falls, and then sensitivity to those movements depends on duration, exactly as it does for a nominal bond.

The second one is the inflation component. If inflation rises relative to what was previously priced by the market, inflation bonds tend to outperform nominal bonds. If inflation falls versus market expectations, the opposite will happen.

This is why saying “I think inflation is going to be 2.5% or 3%, therefore I should buy an inflationary bond” is not enough. The question that an investor should ask is “what inflation is already priced by the market?” Today, the market pricing for future inflation is slightly above 2%.

If you believe realised inflation will be persistently higher, that can create an opportunity. And we think it does today.

That is precisely where active management becomes interesting. Because once you understand that performance come from the interaction between real yields, inflation expectations, duration and realised inflation, you realise that there isn’t simply one inflation trait. There are potentially very different opportunities across maturities and across countries. And the asset class allows you to explore all of this.

AC: Okay, so today we’ve got an environment where we think inflation is going to be higher than what the market’s pricing. Real yields are at what we think are attractive levels. They’ve risen, they’re perhaps at a level that makes sense for investors. Let’s talk about the different sorts of instrument we have for investing [in] inflation-linked bonds, and what sort of approach would you consider at the moment?

ER: For us, there are two important dimensions to this question. The first is global versus single country exposure or currency. The second is active versus passive management.

Let’s start with the global versus single dimension. Inflation is a global phenomenon, but it is certainly not synchronised. The US, the Euro and the UK, which are the main markets, can be at very different stages of their inflation and monetary policy cycles, so the sources of inflation can also be different. At one point the opportunity may be in US TIPS (Treasury Inflation-Protected Securities) – like last year with Liberation Day – and another point in Euro inflation or UK, like this year with the energy shock.

That makes differently attractive markets. Why limit yourself structurally to a single market when a global universe give you a much broader opportunity set and allows you to diversify the sources of inflation exposure?

The second point is active management versus passive. Inflation bonds are particularly well suited to an active approach because the asset class has many performance drivers.

Passive indices or passive benchmarking are built according to issuance of market capitalisation. That does not necessarily mean they give you the exposure that is most attractive from an investment perspective. They can also have significant duration exposure depending on what you’re choosing.

For an investor looking primarily for inflation protection, taking a very large amount of long duration interest-rate risk may not always be desirable, [as] was the case in 2022. That’s one of the reasons why we prefer the short part of the curve. It allows us to capture inflation exposure while limiting some of the volatility associated with very long duration bonds. And within that universe, active management allows us to make several decisions.

We can decide which markets we want to favour, where on the curve we want to be positioned. We can actively manage real duration exposure, and can assess where inflation expectations, so called breakevens, look cheap or expensive relative to our macroeconomic view.

So again, rather than simply buying the global inflation in bond markets as it exists, we’re trying to identify where we believe investors are being best compensated for the risk they are taking. In the end, for the investor, the objective is therefore quite simple. You don’t have to decide yourself where you buy TIPS, euro area linkers, or just one country in the EU, or UK linkers. Which maturity should you own or when you should adjust that exposure? That is the role of active management.

If I had to summarise in one sentence, I would say inflation protection should not necessarily be a tactical trait. On the next CPI (consumer price index) print, it can be a structural component of a fixed income or multi asset portfolio and we believe that a global actively managed approach is a particularly efficient way of accessing it.

AC: Elida, thank you very much. That’s a very clear analysis of where we are and how investors can access the opportunities within inflation-linked bonds. Thank you very much for joining me.

ER: Thank you again for having me. It’s always a pleasure.

AC: That’s it for this week’s episode of Talking Heads. If you’d like to learn more about inflation-linked bonds or any other of our investment insights, please reach out to your BNP Paribas Asset Management contact or check out Viewpoint, our website for investment insights at Viewpoint.bnpparibas-am.com. Viewpoint brings you commentary and analysis in a variety of formats, from investment outlooks to asset allocation videos and podcasts to help investors make better informed decisions.

You’ve been listening to the BNP Paribas Asset Management Talking Heads podcast with me, Andy Craig and Elida Rhenals, Co-head of Inflation and a Senior Portfolio Manager in the Fixed Income team.

Please do join us again next week. Until then, take care.