Five ways bond investors can protect against inflation

“Bond investors are the vampires of the investment world. They love decay, recession — anything that leads to low inflation and the protection of the real value of their loans.”

Those were the words of the world’s most famous bond investor, Bill Gross. And they were a very apt way to describe the opportunities that were created by the bloodbath that was the COVID market sell-off in 2020.

But roll on 12 months or so and the sun is now shining too much for those bond vampires. As economies around the world reopen, strong economic growth is leading to high inflation – and that is typically a bad environment for bonds.

Why is it bad? Because the interest rates on bond interest payments are usually fixed, and rising prices (inflation) therefore reduce their purchasing power. If interest rates go up, bond yields do too, which in turn means the price of a bond falls.

So, what does this mean for the bond holdings in your portfolio?

“While this may be the stuff of nightmares for some investors, the reality is that there are a number of ways to mitigate some of these factors and also generate alpha [returns] in the face of this macroeconomic outlook,” says Colin Finlayson, co-manager of Aegon Strategic Bond fund.

In an interview with Octomembers, an app-based community for financial services professional, Colin outlined five ways to deal with reflation fears: duration and yield curve positioning; inflation-linked bonds; high yield bonds; bank debt; and floating rate notes.

1. Duration and yield curve positioning

“The simplest and most effective way to deal with a move higher in government bond yields is to reduce the level of duration – this reduces the sensitivity of the fund’s returns to higher bond yields,” explained Colin.

The duration of a bond is how sensitive it is to interest rates. The longer a bond has until maturity, the more time it has to be exposed to inflation and therefore the likelihood of increased interest rates.

In his latest quarterly review, Richard Woolnough, manager of M&G Optimal Income, M&G Strategic Corporate Bond and M&G Corporate Bond funds said he was underweight duration across all three funds. “In terms of our [Optimal Income] portfolio duration of 3.0 years, we remain underweight by around four years versus the benchmark,” he said. “This low duration position, although slightly longer compared to the approximately 2.4 years at the end of 2020, is consistent with our negative view of interest rates risk.”

Read more about the yield curve in this article: What is a yield curve and why should you care?

2. Inflation-linked bonds

A more obvious alternative to holding conventional government bonds would be inflation-linked bonds. As the name suggests, inflation-linked bonds help protect investors because the principal and interest payments rise and fall with the rate of inflation.

Jim Leaviss, co-manager of M&G Global Macro Bond, said in his last quarterly report, “To help protect against a scenario of rising growth and inflation expectations, we continue to hold US Treasury Inflation Protected Securities and other inflation-linked bonds, which we think offer cheap insurance against the risk of higher inflation.”

3. High-yield bonds

Unlike their investment grade cousins, high-yields bonds are much less sensitive to changes in government bond yields. Colin says this asset class can often see a rise in value during a reflation phase, given that many areas of the high-yield market are pro-cyclical, benefitting from the rise in economic activity.

Jupiter Strategic Bond fund currently has more than half of the portfolio in high yield bonds (53%*) and almost 30%* in Asia and emerging market bonds, which tend to have higher yields than bonds from developed markets too. Elite rated funds focusing specifically on high yield bonds include Man GLG High Yield Opportunities and Baillie Gifford High Yield Bond.

4. Bank debt

After years of struggles, the banking sector could be well placed to benefit from an inflationary backdrop. Both the combination of higher economic activity and a steeper yield curve is certainly supportive for bank profitability, especially in a low interest rate world.

A number of Elite Rated funds favour financial debt at the moment, especially sub-ordinated bank debt which offers a more attractive yield. GAM Star Credit Opportunities specialises in this area and Gary Kirk, co-manager of TwentyFour Dynamic Bond fund, explained subordinated bank bonds and asset backed securities and told us why they are attractive for investors in today’s environment in this podcast:

5. Floating Rate Notes (FRNs)

Floating Rate Notes (FRNs) are bonds that have variable coupons and are liked to a market rate. They are often popular in periods when people think interest rates are going to rise. This is because when you buy a bond, you lock in a coupon (interest) rate. So, if you buy in a low-rate environment, you will be stuck with that coupon even when interest rates start to rise. A floating rate note’s coupon, however, is designed to rise (or fall) in line with its reference rate.

Premier Miton Multi-Asset Monthly Income fund has a relatively high percentage of its bond portfolio in floating rates, which have produced positive returns this year. SVS Church House Tenax Absolute Return Strategies has also used FRNs to good effect over the years and currently has just shy of 34%** of the portfolio invested in them. Co-manager of the fund, James Mahon, told us more about them in this video (skip to 4 mins).

*Source: fund factsheet, 31 March 2021
**Source: fund factsheet, May 2021

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