Paying heed to inflation risk
As concern continues about the implications of inflation, institutional investors are turning to inflation-linked products to mitigate the risks. Investment vehicles such as the global inflation-linked bond portfolios managed by Fischer Frances Trees and Watts (FFTW) provide one type of solution for managing inflation risk.
FFTW won their first Asian GILB client in February and Yiu expects more interest from institutional clients in the region, especially in the short term, as economic trends foster concerns about inflation risk. The firm manages a number of inflation-linked bond mandates, and their global product has been receiving increased attention from Asian institutional investors wanted to hedge out inflation risks in their portfolios.
Jenny Yiu, GILB portfolio manager and global rates alpha specialist at FFTW, says: “Asian institutional investors are very concerned because the perception is that Western central banks are printing money and accumulating debt.” As they watch what is happening in the United States and in Europe, their concern about inflation is rising.
At the same time, they are also taking note of other themes. “As you look at the global economy, the growth is coming from emerging economies. A growing middle class and a rebalance towards domestic consumption has been driving up commodity prices,” said Yiu. For people who believe in these themes, inflation hedging is paramount.
“We have put together portfolios that seek to outperform their benchmark,” said Yiu, and the benchmark is itself based purely on global inflation-linked bonds. It provides this by exploiting pricing inefficiencies through an active management style. The target is a 75 basis point excess return annually, and Yiu’s team has delivered that with a rolling three-year track record.
What distinguishes Yiu’s products from its competitors in the global inflation-linked space is that her portfolio achieves this return by employing a “pure play” strategy, making allocations only to sovereign inflation-linked bonds as well as their nominal comparators and exchanged traded futures on sovereign bonds. Returns are thus true to the asset class and free from volatility that could be derived from outside the asset class. It also ensures low correlations with other allocations within a client’s fixed income program.
The portfolio focuses on nine different issuing countries; these are all developed countries, because, said Yiu, “these are markets with relatively deeper liquidity and consistent issuance,” and the bonds in the portfolio have a minimum credit rating of single-A. Japan is the only Asian nation represented in the product.
“Some managers take more risks, using, for example, mortgage-backed securities to enhance risk or holding riskier sovereign bonds, such as Greece, because the yield is attractive,” noted Yiu. FFTW takes a more focused approach, which enables Yiu’s team to focus on studying just one market and providing a return true to the asset class. This suits the product’s client base, said Yiu. “Most of our clients are central banks, pension funds, or sovereign wealth funds, which tend to be a little more conservative,” she explained.
The returns of inflation-linked bonds are not only driven by the level of inflation, holders of inflation-linked bonds can incur capital gains or losses as interest rates fall or rise, because inflation-linked bonds are hybrid securities - a traditional fixed income instrument with returns linked to inflation. In addition, its hybrid nature means that its returns are particularly stable, noted Yiu
Under conditions of low inflation, the less favorable income on the bonds coming from inflation linkage (also called inflation accruals) is usually compensated by capital gains, as central banks typically keep interest rates low in such an environment. Conversely, central banks tend to raise interest rates during high inflation scenarios, and capital losses caused by rising interest rates would be mitigated by the increase in inflation accruals. While the relationship between interest rate and inflation helps to explain the stability of inflation-linked bonds return in most cases, there are also exceptions, when this relationship is less straightforward.
The current environment—with domestic economic difficulties in developed markets keeping interest rate at extremely low levels, while global forces drive commodity prices higher, feeding into moderate increases in consumer prices—is very favorable for inflation-linked bonds.
Ultimately there are some scenarios that challenge the portfolio’s returns. Yiu gave one example: “In the fourth quarter of 2008, after the Lehman Brothers bankruptcy, our portfolio did not enjoy the flight to quality rally because investors were expecting economic contraction and were experiencing a fear of deflation,” she outlined. Inflation-linked securities, even though they are government securities, are less liquid than treasuries, and when liquidity is tightening, this situation is not favorable.