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26th Mar

Inflation: the biggest threat to your bond portfolio?

One of the big investment stories of the past decade has been the rush into fixed-income investments, most recently directly into “retail bonds” issued on to the London Stock Exchange’s bond platform. However, as inflation continues to exceed targeted levels how do investors immunise (hedge) the income (coupons) from their bond portfolios against this threat?

The rate of inflation measures the rise in the cost of goods and services in an economy over time; rising inflation erodes the purchasing power of your money.

In the UK this is measured by different indices, e.g. the Consumer Price Index. As many bond issues have fixed coupons, inflation is one of the risks to consider when investing. The desire to protect the bond against inflation highlights a major divergence in the requirements of the issuer (borrower), and the investor (lender). In periods of ‘high or rising’ inflation what is good for the borrower will not always be in the best interests of the lender.

“Simply investing into high yielding bonds will leave investors with a very unbalanced portfolio”

Currently, with interest rates at historically low levels it benefits issuers to fix the rate at which they borrow. However, from an investor’s perspective, with inflation ahead of the government’s target level does investing into a fixed rate bond, even if it has a ‘high coupon’, hedge the inflation risk? A sub-investment grade or unrated issuer may offer a fixed rate coupon that is optically attractive but it may not offset the effects of inflation over the life of the bond. But, let’s not forget that the high coupon was originally offered in return for accepting what many would regard as the additional credit risk of the issuer. Expecting this coupon to act as a hedge against inflation undermines the original rationale for purchasing the bonds in the first place, and reduces the buffer being paid for accepting greater risk. Simply investing into high yielding bonds will leave investors with a very unbalanced portfolio, and inadvertently accepting a level of risk well beyond what is suitable for them.

Floating (variable) rate securities, where coupons increase as interest rates or inflation starts to rise are a potential solution. This inflation linkage is important if you are a bond investor, since the vast majority of conventional (fixed rate) bonds can fare badly in times of high inflation. Floating rate securities, especially those linked to inflation, allow investors the opportunity to preserve the purchasing power of their coupons over the duration of their investment.

So, where do I find the floating rate securities linked to inflation? Like most things this is easier said than done.

The government issues Index-linked Gilts, often referred to as ‘linkers’. Whilst they deliver what they say, i.e. coupons and a return of capital linked to RPI, they can be difficult to access:-

  • In the primary market new issues of Index-linked Gilts are heavily over-subscribed by institutional buyers, retail investors get ‘overlooked’; issues tend to be longer dated as the major buyers look to hedge liabilities of a similar duration.
  • In the secondary market prices reflect supply and demand. For example, recent interest in linkers has led to prices rising considerably. The offer price of an ORB listed linker redeeming in 2020 has risen from 367 at the beginning of the year to circa 390 today )

What about corporates issuing ‘linkers’? As mentioned previously, in the current interest rate environment fixed rates are their preferred route. Of the three linkers that have issued onto ORB, two, National Grid and Severn Trent, are utility providers. Their income is linked to inflation, as we can all see when each year’s bills arrive on our door step; as such they are ideally placed to issue linkers as any increase in coupon payments linked to inflation is effectively matched by increases in their revenue.

Most other corporates do not have this luxury, and whilst it is possible to hedge the risk with a bank, the need for derivatives, and the documentation and infrastructure required to support them is both complicated and expensive for the issuer.

So, where does this leave the investor?

  • A high fixed rate may, or may not work, and could mean taking on an increased degree of credit risk
  • Index-linked Gilts are ideal if you can access primary market issuance, or buy in the secondary market when prices look ‘favourable’. This is likely to mean when the inflation risk is ‘low’ making buying them counterintuitive.
  • Inflation linked corporate issuance is also good but the reality is that issues are limited to investment grade corporates and issuance is rare due to the uncertain nature of the cost of servicing the coupon, and the difficulty they have hedging this risk

Whether it be Government issued debt or investment grade corporates, it is likely that returns will be on the low side and will likely be unattractive to those investors who have been happily buying high headline coupon rates from lower rated corporates. A review of recent issues reveals that inflation linked issues have been sporadic at best. National Grid and Seven Trent were almost 18 and 10 months ago respectively. Inflation linked Gilts are a similar story and the last NS&I issue was 18 months ago.

So far, so bad. However, for once the banks are in a position where they can potentially provide the solution. As mentioned previously, it is possible for corporates to issue linkers but it is hedging the risk of maintaining inflation linked coupons that deters them. Banks are different beasts and have large global funding programmes, often referred to as MTN programmes. Within these programmes they are well placed to issue bonds linked to all manner of underlying indices and asset classes, e.g. equities, commodities …. So, why not an index such as RPI?

The answer is yes, banks can issue bonds over indices such as RPI. In many instances banks still have better credit ratings than other corporates, meaning that you can have RPI linked coupons from investment grade issuers, matching the suitability requirement many of many retail investors. For retail investors this could be the breakthrough they are looking for, albeit that coupons are likely to be modest compared to the high returns offered by non-rated entities. However, market sentiment appears to be changing and retail investors are increasingly requesting RPI linked products. Just how strong this demand is has yet to be quantified, but investors should look out for the launchof such products from Linear Investments as we gauge demand and make more issues available over the coming months.

Conclusion

As with all investment decisions things are never black and white. What you can say is that a fixed coupon gives you certainty of a specified level of income, the value of which may be eroded over time. Floaters can help hedge your portfolio against the effects of inflation, but the level of income will be unknown.

Modern portfolio theory is based on diversification, not just different asset classes but also within investment types. Perhaps a bond portfolio should feature some or all of the following:

  • different maturities; long-dated bonds can pay higher coupons, and staggering redemption dates provides on-going planning
  • different coupons – both fixed and floating
  • different credit risks – a portfolio of AAA bonds will be very safe but pay little income, equally, a portfolio of sub-investment grade or unrated bonds will pay ‘high’ coupons but with a commensurately high risk to capital

Philip Gilbert has over 25 years’ experience dealing with IFAs in both marketing and sales, working for life companies, and more recently as an investment banker with HSBC. He currently works at Linear Investments Limited heading up primary issuance within their Fixed Income division.

Cvetan

Posted on 19/10/2013 18:07:24

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