Why consider Inflation-linked bonds in your asset allocation

Across developed markets, inflation has fallen substantially compared to this time last year. We have observed that when inflation decelerates, investors tend to look less at the asset class and this type of decisions are taken which is a shame as it is in this context that one could buy inflation protection at more attractive levels.

We expect inflation to normalise this year, however the question whether it will normalise at the 2% target of central banks is more uncertain. While it is down compared to this time last year, headline numbers remain stubbornly above 2%: In the US, December was 3.4% and in the eurozone it came in at 2.9%.

There seems to have been a change in the inflation regime meaning that the average inflation should be higher and more uncertain than over the past decade. This is fuelled by factors such as geopolitical risks, that could add pressure on commodities prices, climate change and the green transition.

While we strongly believe in the need for the green transition, there will be a cost in order to achieve it. In order to disincentivise the use of fossil energy, it is likely there will be higher taxed imposed may result in higher prices. While, the need for new investments in order to create production of green energies may also mean increasing prices in the near or medium term. This could temporarily creating supply/demand imbalances.

Finally, the higher recurrence of climate adverse events being experienced globally is likely to lead to an increase in prices with food inflation and transportation services particularly sensitive.

How low can we go?

One of the main key takeaways from the covid crisis from an inflationary impact perspective was that low inflation can still harm real value of assets. Therefore, inflation protection could be considered a key component of the core allocation of a portfolio:

This is because in periods of inflation deceleration, investment opportunities arise for investors looking to protect their portfolios from the inflation risk as buying protection is less expensive than in periods of rising inflation. Currently, inflation breakevens are below ,or close to, 2% in the near and medium term, meaning very low risk premium.

Inflation Swaps 2 years

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Source: AXA IM, Datastream as of 31 January 2023

Since breakevens have repriced lower, we see the second leg of the rally to come from a downward shift in real yields if economies experience a fall in inflation and central banks accommodate this with an adjustment to their policy restrictiveness. As seen in the chart below, real yields are a proxy for growth in the long term.

CPI 5-year swap vs Realised Inflation

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Source: AXA IM, Datastream as of 31 January 2023

How to approach inflation linked bonds in a potentially low inflationary environment.

Inflation is falling but may not return to the previous 2% target levels and, meanwhile, there are several quite important upside risks factors that may create volatility for inflation prints into 2024 and beyond. Therefore, it could be worth considering how to generate returns from inflation-linked bonds in different market configurations.

For those seeking to hedge the inflation risk or take advantage from attractive pricing for inflation protection, having a flexible approach to inflation-linked bonds may be worth considering.

While if you are looking for inflation protection but also do not want to take on too much interest rate risk while rates remain high, considering a short duration strategy is one way to optimise this goal. This low duration approach should enable a higher correlation of the total return to realised inflation in a low rates environment.

Although headline inflation continues to fall, the inflation story is far from a straightforward one and this is why, we believe, inflation-linked bonds may still have a role to play for investors.