Fixed income in an inflationary environment
How bonds have blossomed into favour over the past 12 months
The past 18 months have seen global inflation soar and interest rates rise to counteract it.
As many central banks are at, or approaching, peak rates, the expectation is that inflation will continue to come down to reach governments' targets.
That said, what will happen with the US is still up in the air, with the Federal Reserve suggesting its own period of tightening is not yet over - and we may see rates higher for longer.
In the UK, the target inflation rate is set at 2 per cent, and although rates have now risen to 5.25 per cent, the Bank of England paused in its rate-rising cycle in September, thanks to better-than-expected inflation data, signalling a downward trend.
But while base rate rises may be bad news for people on the cusp of remortgaging, it is good news for both cash savers and those investing in fixed income.
In September, UK bond yields continued their recent upward march, rising 0.1-0.2 per cent at the end of September (a little behind their summer peak) while 10-year US Treasury yields hit a new high of 4.6 per cent - and may rise further still, potentially pushing yields up and bond prices low.
But generally, what should bond investors and their advisers make of this new-found attractiveness for fixed income?
The CPD feature that follows aims to explain some of the factors that might attract and affect clients.
simoney.kyriakou@ft.com
How fixed income has bloomed amid this inflationary environment
For more than a decade after the financial crisis, fixed income investors enjoyed rising bond prices as low inflation, rock-bottom interest rates and quantitative easing created an ideal backdrop for bond holders.
More recently, however, the bond markets have been a little rockier. Soaring inflation and rising interest rates saw bond prices plummet last year, and yields were not high enough to counteract double digit inflation.
But many commentators are predicting that the worst is over for bond investors. In fact, analysts say that if inflation continues to fall and interest rates have hit their peak, investing in fixed income now could be a smart move.
Against this backdrop, what role can bonds play in an investment portfolio, and how can different types of bonds protect against inflation?
This guide will explore the opportunities in the bond market despite high inflation, and comes with an indicative 30 minutes of CPD.
Fixed income kryptonite
Typically, inflation makes bond investors anxious — and for good reason.
“Why own a bond yielding 3 per cent if inflation is 6 per cent?,” says Richard Carter, head of fixed interest research at Quilter Cheviot. “High inflation often goes hand in hand with high interest rates too, which are not good for fixed coupon bonds.”
If inflation goes up, and reaches a point where the rate exceeds the coupon or yield paid, then you are losing money in real terms.
On top of this, rising inflation typically means that central banks will raise interest rates to tame it. In the UK, the Bank of England has increased its base rate from 0.1 per cent in December 2021 to 5.25 per cent today.
Inflation to fixed interest is what kryptonite is to Superman.
Bond issuers will therefore have to offer a higher coupon to attract buyers, and the price of existing bonds will drop so that the yield heads skyward.
A bond worth £100 that pays out £4 yields 4 per cent. If the market changes, and similar bonds begin to pay 5 per cent, the bond’s price will lower to around £80, meaning the £4 coupon would be a yield of 5 per cent.
“If you had bond investments going into this period of high inflation, you will have lost money on them,” says Hal Cook, senior investment analyst at Hargreaves Lansdown.
“High inflation on its own is bad for the fixed income part of an investment portfolio. High inflation accompanied with interest rate rises is worse still.”
As Thomas Becket, from the chief investment office at Canaccord Genuity Wealth Management, says: “You could say that inflation to fixed interest is what kryptonite is to Superman.”
(Article continues below)
Marigold in blossom. (Niko D/Pexels)
Marigold in blossom. (Niko D/Pexels)
(Jess Bailey/Pexels)
(Jess Bailey/Pexels)
(Max Andrey/Pexels)
(Max Andrey/Pexels)
Source: BoE/FTAdviser. (Image: Envato Elements)
Source: BoE/FTAdviser. (Image: Envato Elements)
Fighting inflation with fixed income
Not all bonds suffer the same fate, however.
The worst affected over the past year are those with low yields, such as government bonds and high-quality corporate bonds, and those with a long duration (a measure of how much a bond’s price might change if interest rates fluctuate).
“Fixed income covers an enormous and broad range of opportunities with different characteristics,” says Max Newman, direct equity specialist from wealth manager Atomos.
“Higher risk segments such as high yield and emerging market debt can be relatively less sensitive than government bonds to inflation and interest rate dynamics.”
In a well-balanced portfolio, it often makes sense to keep a small portion of assets invested in high-yield bonds.
Such bonds can typically fare better in a high inflationary environment due to the presence of credit risk – the risk that the issuer may default on payments before the bond reaches maturity.
As the risk is higher, you are paid a higher yield, so you have a higher chance of matching or beating inflation.
Shannon Kirwin, associate director of fixed income strategies at Morningstar, agrees. She says: “In a well-balanced portfolio, it often makes sense to keep a small portion of assets invested in high-yield bonds, because of their higher return potential and yield cushion effect they can offer.
“These kinds of securities tend to be less sensitive to changes in interest rates than high-quality bonds, meaning that they can actually outperform when central banks are raising rates.”
While analysts agree that looking to higher-yielding (and therefore higher risk) areas of the bond market could help your investments in a high inflationary environment, some were quick to point out the risks.
“To counteract rising prices, central banks will begin tightening their monetary policies, as seen over the past 15 months,” notes Thomas Gehlen, senior markets strategist at SG Kleinwort Hambros.
“In the corporate sector, this will increase the cost of borrowing and put pressure on balance sheets, especially for businesses that are seen as riskier investments already. Hence, the sectors that commonly populate the high-yield bond market are at even higher risk of default.”
Eduardo Sánchez, associate research director of fixed income at the research firm Square Mile, suggests floating rate notes, which are bonds where the coupon payments are linked to the level of interest rates.
“These have no interest rate risk,” said Sánchez. “As bond yields rise, their coupon payments rise, so these bonds become more attractive. As the returns increase as rates increase, they provide protection against inflation.”
And Carter pointed out that shorter-date inflation-linked bonds could provide some protection, as their principal payments were inflation-linked.
The passive dilemma
Most analysts advised against investing in a bond benchmark (or a passive fund), especially at times of high inflation.
Cook says: “Bond markets have lots more constituents than stock markets. The FTSE 100 has 100 companies’ share prices, but each of those companies will have multiple different bonds available to invest in, all of different sizes and different coupon payments and maturity dates.
“There is much greater scope for an active bond manager to add value over a benchmark as a result of this.”
Active management could be particularly helpful where there was credit risk, according to Frédéric Taché, head of fixed income at St James’s Place.
This could well be a better return than equity markets in a world where in the short term, profits are under pressure.
This was because of the high uncertainty and the challenges surrounding liquidity, and he says active management could provide “significant” added value.
Carter agrees, although suggests passive funds could play a role depending on the benchmark you choose. For example, while a standard all-maturity government bond benchmark was unlikely to perform well, short-dated inflation-linked bonds could do better.
A powerful opportunity?
If bonds suffer in periods of rising inflation and interest rates, the opposite is true when rates are coming down and inflation is moving from high to medium.
“Clearly, inflation is not positive for fixed interest investments as real returns are impacted from higher rates of inflation,” says Becket.
“However, buying fixed interest investments when inflation is high but could be about to be moderate could be a very powerful investment opportunity.”
The BoE held its base rate at 5.25 per cent at the latest monetary policy committee – the first time since December 2021 that it has not pushed the rate skyward. In the meeting minutes, the central bank said that inflation was expected to return to the 2 per cent target by spring 2025.
Inflation has already started to fall. It peaked at 11.1 per cent in October 2022 but the Office for National Statistics recorded a rate of 6.7 per cent for the year to August. This is the lowest yearly figure since March 2022.
While bonds undoubtedly had a bad 2022, analysts point to the future as a good time to be a bond holder.
Sanchez says that investors had already experienced the bulk of their bond losses relating to high inflation over the past few years, and now have a higher expected return than they would have done six, 12 or 18 months ago.
“When you are investing money in bonds, it doesn’t really matter what the current level of inflation is,” Kirwin says. “What matters is what the future level of inflation is going to be.”
Any bond you buy today is going to have an expected future level of inflation priced in; if you buy a 10-year bond today, the coupon on that bond will reflect the market’s assumptions on how much you are going to need to be compensated for inflation.
Let’s say you buy a 10-year government bond with a 5 per cent coupon. Around 3 per cent of that coupon is compensating you for having your cash tied up for 10 years, and the remaining 2 per cent is for what the expected average annual rate of inflation will be over the next 10 years.
If inflation is less than 2 per cent over this period, you will have made money. If it is more, you have lost money, says Kirwin.
How you view the future of your fixed income investing depends on what will happen to interest rates and inflation going forward.
Tache says: “If you take the view that central banks’ hawkish policies have been sufficient or are reaching an end, then you can target securities with fairly high credit quality and some level of duration risk to achieve a comfortable level of yield to beat the inflation target.”
For Becket, the bond market has returned to “normality” – the sort of returns you could get before the financial crisis, when the fixed income part of portfolios would churn out returns of between 5 and 6 per cent.
He forecasts that we have moved to a world where US Treasury yields are between 4 and 5 per cent, UK investment-grade corporate bonds yield 6 per cent and high yield and emerging market bonds offer a prospective 8 per cent.
Becket adds: “If you can put together a globally diversified, multi-asset fixed income fund, with a controlled level of duration that yields between 6 and 7 per cent, this could well be a better return than equity markets in a world where in the short term, profits are under pressure.”
Imogen Tew is a freelance financial journalist
Built with Shorthand