Inflation-linked bonds and why they matter

MoneyMarketing spoke to Jaco-Chris Koorts, Portfolio Manager at Sanlam Investments Multi-Manager, about inflation-linked bonds (ILBs) and why they make sense in a well-rounded portfolio today.

With inflation remaining an important consideration for long-term investors, what role do inflation-linked bonds play in a diversified portfolio, and where do you see their greatest value for investors today?

Unlike nominal bonds, inflation-linked bonds (ILBs) carry an explicit inflation protection in the sense that their cashflows are adjusted upwards or downwards in line with the headline Consumer Price Inflation (CPI) index. 

As such, whereas nominal bonds carry the risk of the buying power of their cashflows being eroded by inflation being higher than expected, there is no such risk for ILBs.

To answer the question of whether or not there is value in ILBs for investors today, one has to understand the concept of break-even inflation. The break-even inflation rate is the difference between the Nominal SA Government Bond Yield and the ILB Real Yield. At the time of writing, the Nominal SA Government Bond Yield was around 8.9% and the ILB Real Yield was around 4.2%, which means that break-even inflation was around 4.7%. ILBs will outperform nominal bonds if the actual inflation rate is above this rate. The question therefore becomes a subjective call on the likely future inflation rates. Although South Africa’s headline inflation rate peaked at 5% in June, it has come down to 4.3% in July, and making a definite call on the future inflation rate is very difficult in the current macro-economic environment.

How should advisers think about the trade-off between the inflation protection offered by inflation-linked bonds and the potentially higher nominal yields available from conventional government bonds?

Despite the defensive characteristics of ILBs, they are not risk free. This is mainly because they have a high modified duration and thus bring high volatility with them into a portfolio. Because many benchmark government ILBs have long durations (2038, 2046, and 2050) and relatively small real coupon rates, their modified duration is high. This means that if yields on these securities push up, ILBs tend to experience sharp capital drawdowns, and vice versa.

South Africa’s inflation outlook has changed significantly in recent years. How do changing inflation expectations affect the attractiveness and pricing of inflation-linked bonds? 

As mentioned previously, whether or not ILBs offer attractive value depends on the break-even inflation calculation. With break-even inflation standing at around 4.7% in the current yield environment, we see this is much higher than the newly-adopted 3% inflation target of the South African Reserve Bank (SARB). Given the SARB’s historic credibility to keep inflation under control, coupled with the fact that ILBs will outperform if actual inflation is higher than this rate, it looks at first glance as if the easy money in ILBs has been made.

However, in the context of the current macro-economic environment where high oil prices are pushing inflation higher, it is not impossible that inflation uncertainty elevates the relative attractiveness of ILBs as an investment option.

What are the key risks or misconceptions advisers should be aware of when considering inflation-linked bonds for clients, particularly in terms of real yields, duration and capital volatility? 

ILBs are not risk-free and carry a high modified duration and therefore high volatility. Another factor to keep in mind is that ILB adjustments use historical CPI data, which is typically lagged by approximately three months in practice. Therefore, during sudden, sharp spikes in inflation, the inflation protection does not kick in immediately. An adviser thinking about adding ILBs to a client’s portfolio must therefore prepare the client for this short-term volatility. Although an ILB guarantees purchasing power at maturity, its price path along the way fluctuates based on prevailing real interest rate movements.

For retirement investors who need to protect their future purchasing power, how can inflation-linked bonds complement other income-generating and growth assets within a retirement portfolio?

For retirees navigating living annuity drawdown strategies, the main threat is sequencing risk compounded by inflation risk. Sequencing risk is the risk of market downturns exacerbating the eroding effect of income withdrawals. Inflation risk is the risk of inflation eroding the buying power of a retiree’s income.

Real assets, such as equities and property, are expected to provide inflation-beating returns over time. However, the returns come with volatility. The most effective way of reducing volatility is by adding diversification to a portfolio. However, it has been shown that during times of extreme market stress, the correlations between nominal bonds, equities, and property trends towards one, i.e. volatility reduces when you need it most. On the other hand, ILBs have historically provided structural diversification during these times.

Looking ahead, what do you think advisers should be watching in the inflation-linked bond market, and under what conditions could these instruments become particularly attractive to investors?

It is extremely hard to time any type of market, and the market for ILBs is no different. This is made even more difficult by the fact that ILBs are a specialist asset class, so in general it is best to leave this to the professionals.

The most practical scenario to look at is likely the emergence of stagflationary (high inflation, low growth) signals. If global supply-chain disruptions or energy shocks push local inflation higher while economic growth slows, equities and nominal bonds may face pressure, positioning ILBs as a potential safe haven.