Inflation-linked bonds could provide investors with a buffer against rising prices, as the UK stands on the brink of a possible recession precipitated by high levels of inflation coupled with low growth.
The Confederation of British Industry warned on Monday that the UK could be heading into a period of so-called “stagflation” where high levels of inflation combine with low levels of productivity to create a recipe for hard times.
Driven by reduced activity in healthcare since the pandemic and price increases in manufacturing supply chains, the current period of stagflation makes it more acute than ever for investors to hedge against further price increases.
“We’re seeing inflation across different markets that we haven’t seen in decades,” said Edward Hunt, head of core income funds at Infrared Capital Partners, speaking on a webcast hosted by the Association of Investment Companies on Monday.
“This topic is absolutely top of investors’ minds.”
Investing in the little-known debt instruments could offer retail and institutional investors a way to hedge against the current inflationary climate, providing a potentially high-risk, high-reward investment opportunity.
But the market is largely untested, particularly when it comes to corporate issuers, and the returns, though attractive on a macro outlook, are not necessarily wholesale bonanzas for investors.
Pension funds are currently the biggest investors in inflation and index-linked bonds and gilts, which can be bought directly from sovereign issuers by institutional investors or invested in through listed vehicles.
Andrew Cowley, who founded listed investment trust Impact Healthcare REIT PLC (LSE:IHR), said that with yields spread over a decade for gilts currently at about 2%, their competitiveness could “cause challenges in real estate”.
However, healthcare yields are even higher and with “100% inflation-linked” leases to care providers on offer, Impact Healthcare REIT has provided 12.3% total returns since inception, Cowley said.
There are currently approximately 32 index-linked bond instruments in issuance in the UK, according to the FTSE Actuaries UK Index-Linked All Stocks Index, representing a £720.8bn market with exposure to volatility in inflation and other indices, according to FTSE Russell.
Returns from the index have been rising since May 2019, but fell this May, offering a warning that high inflation does not always correlate to a bigger upside.
Exchange-traded funds investing in UK index-linked bonds include iShares £ Index-Linked Gilts UCITS ETF GBP ETF, which can be invested in through ISAs, SIPPs and investment accounts, and the Lyxor Core UK Government Bond UCITS ETF.
While inflation crept up briefly in the early nineties, the market for inflation-linked bonds hasn’t been broadly tested through times of intense inflation, particularly among corporate issuers.
The major issuer of inflation-linked bonds is the UK government, which first issued index-linked gilts in 1981, more than a decade after inflation was at a sustained peak.
In its latest bond issuance, the UK government appeared to be hedging its bets against further inflationary rises over the next five decades, selling an inflation index-linked gilt due to mature in 2073 in November at the lowest nominal value of any gilt syndication since 2005.
Gilts typically carry a low risk of default, but government default is not unheard of. The last time the UK government defaulted on a bond was in 1932 related to First World War debt owed to the United States, after defaulting on a war loan gilt issued in 1917.
Inflation-linked bonds could help investors hedge against losses in savings from low-interest rates and rising living costs, but when monetary easing puts a cap on inflation, their value will tumble and this will be reflected in the returns on offer from traded ETFs that invest in them.
In times of high inflation, governments ease inflationary pressure through monetary easing tools such as removing the supply of money from the market, or counterintuitively, increasing interest rates.
The European Central Bank and Bank of England both recently raised their base rates of interest, up from low to negative interest rates since the 2008 financial crash. The federal government is also likely to take fiscal measures to ease the economy, with the US on the brink of a recession, for example by selling off securities and in turn reducing bank lending.
“The significant increases in the cost of living and the interest rate increases are starting to have a detrimental impact on current and future growth... and this is likely to bring inflation meaningfully lower over the medium term,” said BRI Wealth Management chief executive Dan Boardman-Weston.
Inflation-tied infra may be a better choice
Infrastructure investment trusts were once an anomalous investment proposition that sat somewhere between private equity and real estate investment, but have since become a source of reliable inflation-linked returns.
Infrared’s listed infrastructure trust HICL Infrastructure Company Limited (LSE:HICL) was the first of its kind to provide “instant access to illiquid assets” such as public-private partnerships, regulated and other infra, Hunt said, adding that it has generated a total return of 9% per year since its inception in 2006.
Inflation hit a record 9% in the year to April 2022, according to the Consumer Price Index, and could creep even higher by the end of the year. The root cause stems from Russia’s war on Ukraine, with price increases driven by the removal of household and food products from the market, compounding the impact of the pandemic.
Rising inflation this year has contributed to an uplift in the trust's results, Hunt said, adding that if inflation rose above 1% then the listed fund’s net asset value would increase by eight basis points.
“We’re faced with high short-term inflation,” Giles Frost, co-founder of Amber Infrastructure, added while speaking at the AIC webinar on Monday. “Investors can look forward to the forthcoming storm with some degree of comfort.”
Frost noted that the structure of his firm's Infrastructure Public Partnerships portfolio and “negotiations” with government have delivered 13 years of “consecutive dividend growth”, demonstrating that infra investments can benefit from policy assurances.