Inflation-linked bonds are like other fixed-income instruments in that their performance depends primarily on the change in interest rate levels. In contrast to traditional bonds, however, only the real coupon of inflation-linked bonds is fixed. The inflation rate is paid out on a variable basis. For investors who are concerned about the latent potential for inflation, indexed bonds therefore offer "partial insurance coverage" against a rise in interest rates.
The market for inflation-linked bonds remains relatively young compared with the conventional bond market, but it has grown substantially in the last few years. The UK and US initially dominated the market, but over the last 15 years there has been an increasing number of new issues coming from other countries. In addition to the developed economies, emerging countries such as Brazil and Mexico are also issuing such bonds. And the number of issuers is constantly increasing. It is a good time for investors. Thanks to the stable outlook for growth and the promised reflationary fiscal measures in the US, the engine of the global economy could soon be seeing higher inflation rates. Moreover, Europe and Japan are still using ultra-expansive monetary policies to try to boost inflation.
Inflation expectations are still in the midst of a long sideways trend due to the pull of extreme forces in two directions. On the one hand, there is deflationary pressure due to the debt reduction so urgently needed in the public sector, and to some extent in the private sector as well. On the other, there are mounting inflation risks associated with the ongoing very expansive monetary conditions. The scales are thus in a precarious balance.
The statistical base effect, however, which is related to the price of oil, is producing a modest cyclical upturn. Furthermore, inflationary forces may come into play in the US and Japan due to proposed fiscal stimulus programs. This is very much in the interest of the leading central banks, which for quite some time have been calling for fiscal policy support in addition to their ultra-expansive monetary policy. Some market participants therefore even fear that central banks want to overshoot their inflation targets deliberately.
Although the ongoing interest rate normalization in the US puts this scenario into perspective, the economic outlook is more reflationary than it has been in a long time. At times of rising interest rates, anyone who continues to invest in bonds, whether for diversification considerations or due to holding requirements, will find inflation-linked bonds an ideal investment instrument to help diversify a portfolio or protect it against a loss of purchasing power, which is a threat in a reflationary scenario. Inflation-linked bonds should therefore have a fixed place in a portfolio, not merely as a tactical tip, but as a part of strategic asset allocation.
Author: LGT Capital Partners