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Rising inflation often comes with rising yields, which could subsequently lower returns in bonds with high duration - and that’s exactly what we have seen this year amid a broadly bearish market for bond investors. Inflation-linked bonds have gained popularity as a way to buffer the pain from rising inflation expectations. But within this asset class, investors still need to pick the optimal maturities, because different segments come with their own risks and drawbacks.
This week’s Chart Room shows index returns in the market for US Treasury Inflation-Protected Securities (TIPS), where long-dated inflation-linked bonds (10 years and above) are down 10.6 per cent year-to-date (as of 12 March), versus bonds with maturities of 1-to-10 years, which are only down 0.1 per cent. This shows why we prefer 1-to-10 years as the Goldilocks segment: not too long and not too short, they’re just right.
Not too long…
Relative to longer-maturity indices, the 1-to-10 years segment helps to isolate inflation risk and reduce duration risk. In other words, it offers more exposure to inflation carry as a proportion of total return. Inflation carry is the uplift to coupon and principle payments from changes in inflation, and this is what investors typically seek when allocating to inflation linked bonds.
When we zoom out to the global inflation-linked bond market, the 1-to-10 years’ segment also has a more attractive composition relative to full-maturity indices. Specifically, it has more exposure to US TIPS, the largest and most liquid inflation-linked bond market, while carrying less exposure to index-linked Gilts (UK) which are structurally expensive given domestic regulations and subsequent heavy demand for long-dated index-linked Gilts. To illustrate, 10-year UK inflation expectations (or UK breakevens) are currently 3.4 per cent, whereas the Retail Price Index is a mere 1.4 per cent.
And not too short
We also prefer the 1-to-10 year index over shorter-maturity indices such as the 1-to-5 year index, which can be driven by volatile oil price moves. For example, 2-year US breakevens, or the difference in yields between standard and inflation-linked bonds of the same maturity, troughed at negative 6.9 per cent during the Global Financial Crisis, whereas 10-year US breakevens only fell to zero.
While short maturity breakevens looked attractive as recently as last year, we think valuations are less enticing at today’s levels relative to longer maturity breakevens. The market is pricing in more inflation in the US over the next couple of years compared to later periods, with short maturity breakevens higher than longer maturity breakevens.
By focusing on the middle path, the 1-to-10 year segment of the inflation-linked bonds market, investors can reduce exposure to rising yields (duration risk) as well as volatile commodity prices without paying too much. Just like Goldilocks, even inflation-protected strategies can look vulnerable if they’re caught out by the bears.