Beware inflation ‘optical illusions’ it may be time to look at inflation linked bonds

11th March 2015

Jonathan Baltora, inflation linked bonds fund manager at AXA IM believes the relative underperformance of inflation linked bonds may be over as he writes below.

Inflation linked bonds have naturally been underperforming their nominal counterparts in this environment for the last few years. We believe that this trend may well be over as inflation breakevens currently  trade well below the Central Banks’ target and the recent oil price correction is fully priced-in.

Investors should look through the “inflation optical illusions”. While year-over-year headline inflation will likely remain below 0% for some time, we believe monthly inflation, feeding inflation linked bonds coupons, is expected to rebound strongly in the coming months. Investors would therefore be well compensated for buying cheap medium term inflation protection explaining why demand for the asset class has picked-up.

Inflation linked bonds have outperformed nominal bonds[1] in February as investors are taking advantage of historically low valuations and Central Banks are rushing to cut rates and ease monetary conditions to prevent their currency from appreciating. Inflation linked bonds are often an attractive value proposition in a currency war situation.

We believe Euro inflation linked bonds offer value as the Euro area stands to be a winner of the currency war in the year to come. Currency war spillovers have been significant in the inflation linked bond market with Japanese inflation linked bonds outperforming nominal Japanese Government bonds by 9.2%[2] as the Japanese Yen has dropped by more than 50% over the same period against the US dollar. The US dollar has strengthened by 20% since December 2011, however the US TIPS market has underperformed nominal treasuries by more than 4%[3].

Earlier this week, for example, Germany has issued €2 billion of a new bund linker maturing in 2026. German inflation linked bonds do not offer the best value in the Euro area in our view, other issuances such as Italian BTP€i or Spanish BONOS€i look more attractive for our portfolios. However, we believe that as investors are worried about rates potentially going higher at some point in the future inflation linked bonds can protect from one of the two factors potentially sending yields higher (namely real yields and inflation expectations).

The Euro area linkers can offer some protection against rising yields as the ECB will want to see inflation pick-up before lifting its foot from the QE pedal, which would in turn send yields higher.

In our inflation linked bond funds we had as much as 15% of nominal bond holdings up until February 2015 as we wanted to hedge against the impact of falling oil prices, but we have now fully switched back in to inflation linked bonds. We think inflation linked bonds are globally attractive at this point as embedded inflation expectations trade well below Central Banks targets and the ever-expanding Central Banks’ balance sheets should also remain supportive for real interest rates.

We also see opportunities in US TIPS as inflation breakevens are too low when compared to the Federal Reserve mandate. US TIPS should benefit from relatively cheaper real interest rates.  We believe that inflation break evens should gradually widen as inflation pick-up drives investors into the asset class again.”

1.     Fixed rate treasury

2.     Source: Barclays indices from December to 2011 to end of February 2015, Bloomberg

3.     Source: Barclays indices as at end of February 2015, Bloomberg

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