Mission inflation: protection protocol

By Femi Bart-Williams, iShares Fixed Income Product Strategy team at BlackRock

• As investors sought protection from higher-than-expected inflation, 2021 was a record year for allocation to inflation-linked ETFs ($7.8bn).¹
• Allocations to shorter-dated bonds increased over 2021 in response to the risk of potentially higher central-bank rates.
• Investors also diversified into emerging markets fixed-income ETFs and high-yield ETFs, in search of higher and more resilient yield overall.

Inflation protocol – how investors sought protection from higher inflation

Inflation-linked bonds typically have coupons and/or principal repayments that increase with inflation. So, as investors become increasingly concerned about inflation expectations, an increased allocation to inflation-linked assets tends to follow. As inflation concerns were less prominent. In 2020, however, flows were driven primarily by allocations to US and global inflation ETFs.

Holding inflation-linked assets protect portfolios if inflation rises.

Allocation to some inflation-linked assets across some major markets

Fallout – the risk of interest rates rising. What to do?

Traditionally, as inflation increases beyond their targets, central banks would be expected to increase base interest rates. In this scenario we would expect prices of fixed-rate bonds to fall and bond yields to rise. Typically, this move in base interest rates has a greater impact on longer-dated bonds than shorter-dated bonds, given the lower interest-rate sensitivity of the latter. In other words, shorter-dated bonds are a relative haven for those concerned about rising interest rates.

Amid concerns at the prospect of rate hikes by central banks, the net allocation to shorter-duration bonds more than quadrupled in 2021 ($13bn) from 2020 ($3bn)¹, when there was less concern over monetary policy. This was driven primarily by allocations to government and investment-grade bond ETFs.

Diversification across nations

Against the continued backdrop of low rates and increased inflation, flows into differentiated markets accelerated in a search for assets with higher yields and less sensitivity to inflation and expected rate hikes, providing greater diversification and protection to an overall portfolio. This drove flows into emerging markets (EMs) and high-yield markets.

In 2021, EM corporate-bond ETFs gathered $7.5bn, surpassing the $7.3bn from 2020. This flow was driven mostly by China-bond ETFs ($8.8bn) and, to a lesser extent, EM corporate-bond ETFs. Local and hard currency EM flows were negative, at -$1.5bn and -$1bn, respectively¹.

Holding EM bonds can improve yield and diversify portfolio risk

Cumulative allocation to EM bonds across some key markets

Continuing the theme from 2020, the net allocation into high yield continued in 2021, driven by allocations to global and US high yield.

Holding high-yield bonds can also improve yield and diversify portfolio risk

Cumulative allocation to high-yield bonds

In 2022, we expect the themes of 2021 to continue, perhaps with the further addition of allocations to Asian bond markets.

¹ Global Business Intelligence at 31 December 2021

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