Why are inflation-linked bonds doing badly?

According to the latest data from Eurostat, the inflation rate in the euro area in August 2022 reached a record value of 9.1%, compared to 8.9% in July (3% in August 2021). The Italian figure is in perfect line with that of the Eurozone, while in the European Union it was 10.1% in August, compared to 9.8% in July. In short, we have been traveling to the highest levels for 40 years now.

Yet, if we look at the yields of bonds indexed to European inflation, we find that they are losing value. The graph below shows the evolution since the beginning of the Bloomberg Barclays Euro Government Inflation-Linked Bond Index, benchmark of the iShares € Inflation Linked Govt Bond UCITS ETF (IBCI) and of the Lyxor Core Euro Government Inflation-Linked Bond (DR) UCITS ETFs (EMIs), by far the two most important ETFs in terms of masses within their category and both covered by Morningstar qualitative research (the former achieves an Analyst Rating of Silver and the latter of Gold).

The two ETFs (like the index) have been losing more than 7% since the beginning of the year. How is it possible?

Some investors are receiving a lesson on the dynamics of the inflation-linked bond market. The fact that inflation is high and rising does not mean that a fund or an index inflation-linked earnings by force. Indeed, the opposite is often the case. What matters most, in fact, is what is expected to happen to inflation in the months, quarters and years to come.

“This is an area where the relationship appears simple and obvious: why not buy them if inflation rises? It really depends on what the market expects to happen, ”explains Eric Jacobson, a bond strategist at Morningstar. In short, if the market has already priced the current increase in inflation and does not foresee other increases in the future, the value of the bonds linked to the cost of living will not benefit.

Today, with rising inflation, investors expect the European Central Bank to act more aggressively to put out the fire. “The market does not react to inflation news, but to the ECB’s expectations of strength,” says Jacobs. And an ECB expected to be in “hawkish” mode for the next few months crushes the assessments of the bond inflation-linked.

Put simply, those who invested in these bonds in early 2021, when such an inflationary flare was not expected, have certainly benefited. On the other hand, those who bought them pushed by the news relating to the cost of living released in the last 6-8 months are not benefiting from them.

How do they work
Inflation-linked bonds contractually link bond principal and interest to a nationally, regionally or globally recognized measure of inflation. This type of bond is typically issued by a nation’s government, and behaves like a nominal government bond with periodic coupon and redemption at maturity. However, coupon and redemption are linked to inflation, so they can grow in the case of an inflationary scenario.

However, anyone who invests in a fund or an ETF is subject to the market value of the bonds in the portfolio. What does this value depend on? From various variables, but above all from interest rates. Like any other bond asset, inflation-linked bonds are also subject to the relationship between duration and interest rates, only in this case it is the real rates that matter (and not the nominal ones). Recall that the real interest rate is the interest rate net of the current inflation rate.

The right questions to ask yourself
“At this stage of the market cycle it might be tempting to replace a core bond portfolio with inflation-linked bond funds, but investors should be aware that these products have their own, distinct, mechanisms,” says analyst Mara Dobrescu. Morningstar senior bond. “In particular, inflation-linked bond funds, especially in the Eurozone and the UK, are usually issued with longer maturities than simple government bonds. This means that inflation-linked bond funds tend to have a much longer duration, on average, than their nominal bond counterparts, making them much more sensitive to changes in interest rates.

This means that their rate sensitivity could end up nullifying any benefits of inflation indexing if interest rates continue to rise. “For investors who still want to be exposed to this asset class, it is best to limit it to a smaller portion of a larger portfolio, choose a low-cost offering such as an index fund or an ETF, and then keep it for the long term, that is, at least for an entire market cycle ”, continues the analyst.

Faced with such a choice, first “the investor must consider whether it is more important to protect his portfolio from rising inflation or from rising interest rates (since the choice of an inflation-linked bond fund with a long duration it could compromise this second objective). Secondly, when choosing an inflation-linked bond fund, it is crucial to look at the fees, as low-fee products have the best chance of success in the long run, ”concludes Dobrescu.

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About Eric Wilson

The variety offered by video games never ceases to amaze him. He loves OutRun's drifting as well as the contemplative walks of Dear Esther. Immersing himself in other worlds is an incomparable feeling for him: he understood it by playing for the first time in Shenmue.

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