With BoE rates rising from a floor of 0.1 per cent to 1.75 per cent in August 2022 to potentially 3 per cent to 4 per cent by mid 2023 (on current market expectations), that is a sobering thought.
In summary, inflation-linked bonds protect against inflation if held to maturity but are highly vulnerable to interest rates that are typically increased to curb inflation. So investors in inflation-linked bonds reduce their long-term inflation risk but materially increase their near-term interest rate risk.
Bonds that are linked to inflation are therefore highly sensitive to rising interest rates and thus not attractive in a rising rate environment. Investors who bought inflation-linked bonds in 2021 to protect against inflation have learnt this the hard way as the BoE started raising rates in 2022.
Alternatives to bonds in an inflationary regime
If inflation was slightly elevated, for example at 3 per cent to 4 per cent, compared to the target 2 per cent, then investors could consider high-yield (lower credit quality) bonds such as emerging markets bonds and high-yield bonds, while monitoring duration risk.
But with inflation running materially in excess of the highest yielding bonds, no bonds can keep pace with inflation, which means investors have to consider alternative asset classes, for similar level of volatility.
Traditionally, popular alternatives to bond funds have included property and infrastructure funds. We explore some other options too.
Property
As an asset class property has bond-like income that has the potential to pass through changes in inflation. But its capital value, and the use of leverage, mean that is has equity-like properties too.
Open-ended funds with daily dealing investing in less liquid or illiquid property holdings can cause a liquidity mismatch. Property funds typically have a higher volatility level than bond funds. However, while property is a great inflation hedge in positive economic climate, its returns can be negatively impacted by rising vacancy rates, associated with a recession.
For a liquid version of the exposure, property securities (shares in property companies and real estate investment trusts) make sense, but these bring equity-like volatility characteristics, so risk control is key.
Infrastructure
Similar to property, infrastructure receives a steady income (through inflation-linked tariffs and tolls) that can be inflation-linked. As infrastructure is 'always on', it is typically less vulnerable to growth shocks (and therefore more bond-like), than property.
However, infrastructure funds require careful examination of both volatility and liquidity profile. Infrastructure securities funds provide a more liquid format, but again have equity-like volatility characteristics.
Multi-asset infrastructure securities (listed infrastructure debt and equity) provide a lower risk version of this exposure.
Liquid real assets
By combining a portfolio of lower risk-rate-sensitive assets (such as floating rate notes and ultrashort bonds) and higher risk inflation-sensitive assets (such as property, infrastructure, utilities, energy, industrial metals, precious metals, natural resources and gold), investors can achieve a return premium to bonds, with bond-like volatility.
