The strong likelihood of higher inflation in the near future means there is still a good case for holding expensive index-linked bonds, according to investors at Troy Asset Management.
The prospects for higher inflation following June’s referendum result and the subsequent fall of sterling have risen in recent months and signalled a change in behaviour by the Bank of England, with governor Mark Carney acknowledging the potential for increased inflation above its 2 per cent target.
While figures published by the Office for National Statistics earlier this month showed that consumer price index (CPI), the Bank of England’s benchmark for inflation, had fallen to 0.9 per cent in October, expectations remain for further rises in the years ahead.
In its November Inflation Report, the Bank of England had noted that longer-term UK gilt yields had fallen in line with the size of purchases announced following the referendum results but had risen more recently. Yields had also risen more quickly in the UK than the US and eurozone, which the central bank linked to the fall in sterling.
UK RPI inflation over 10 years
Source: Office for National Statistics
While compensation for inflation five to 10 years ahead in the US and eurozone remain “well below historical average levels”, the UK measure – linked to RPI inflation – has remained at past average levels. Indeed, retail price index (RPI) remained steady at 2 per cent in October.
“In part, this may reflect increases in inflation expectations or increased perceptions of risks around future inflation,” the report noted.
“In addition, these measures may also be influenced by other factors. For example, fluctuations in demand from certain investors — such as pension funds and insurers — for hedging the risks associated with liabilities that are linked to future inflation rates can have a material impact on these measures.
“Market contacts suggest that demand from those investors has been particularly strong in recent months, having been more subdued around the time of the referendum.”
FE Alpha Manager Sebastian Lyon, manager of Troy Asset Management’s Trojan fund, says despite the deflationary environment, inflation rises are likely in the coming years. Lyon has index-linked bonds as one of ‘four pillars’ in his portfolio, with them sitting alongside blue-chip equities, gold and cash.
“Whether it is the price of petrol, Marmite or Microsoft Office software, UK core inflation is likely to rise in 2017 and 2018,” said Lyon. “In a previously deflationary environment this seems paradoxical. It may prove temporary, as it was when the RPI rose 5.6 per cent in September 2011, only for deflationary forces to prevail.”
“Should sterling weakness become sustained inflation could become more endemic. Interest rates did not move up five years ago, and we would expect the MPC [Bank of England’s Monetary Policy Committee] to argue again that inflationary pressures will prove short-lived.”
The demand to hedge risk against further increases in inflation has made index-linked gilts looked attractive for investors, particularly in a low growth environment, the manager argues.
Asset allocation of the Trojan fund
Source: Troy Asset Management
“With short rates staying low, conventional bond yields may not rise by much. In 2011, 10-year gilt yields were 2.3 per cent. Today they are half that. The result will be negative real interest rates. Here lies the reason for our preference for index-linked gilts and US TIPS [treasury inflation-protected securities].”
He added: “Higher inflation is also a threat to ever higher earnings multiples on stocks. We have warned in the past of the fallacy that inflation is good for stock markets. There is a risk to margins as input prices rise. With stretched valuations future profits will be worth less at today's values.”
However, the strategy is not without risks. Troy investment analyst Charlotte Yonge says that inflation-linked bonds are currently yielding “a little below zero in real terms”, locking in a slightly negative real return if held to maturity.
Yet, the prospect of further inflation – particularly as governments are left with few options to reduce debts – seems likely in Troy’s view and justifies the holding of an asset that some consider to look expensive.
“With sufficient growth elusive in most, inflation provides the only reasonable chance of reducing the debt – absent an outright default. Policymakers know this well. On balance, inflation-protected securities would appear a sensible place to be,” Yonge said.
“In the absence of an opportunity to sell our index-linked bonds at a higher price before maturity, we stand to lose around 1 per cent per annum in real terms over the next five years.
“Substantial weakness in our index-linked bond holdings before then – whether prompted by deflation or inflation-led expectation of higher interest rates – would likely lead us to switch part or all of them into the more attractive of either equities or longer-dated inflation-protected securities.
“If such a sell-off occurs in both equities and index-linked, shorter-dated index-linked bonds will suffer the least,” she added. “At a time of famine, this asset class may not sate our hunger but it should keep us from starving.”
Lyon said: “In a world where steering a course between inflation and deflation becomes harder, not just for central bankers but for investors as well, forecasting the next few years is extremely difficult.
“Navigating febrile, volatile and illiquid markets is likely to become more challenging as investors are forced to cope with political and economic extremism. There is still good reason to hold inflation protection.”
Performance of fund vs sector and index since launch
Source: FE Analytics
Since launch in May 2001, the £3.5bn Troy Trojan fund has posted a 216.03 per cent total return – compared with 124.72 per cent from its benchmark FTSE All Share index and 93.02 per cent from its average IA Flexible Investment peer.
Over this time frame, it has also posted the sector’s lowest annualised volatility (at 6.60 per cent) and maximum drawdown (at 9.81 per cent), as well as its best risk-adjusted returns as measured by the Sharpe ratio.
Troy Trojan has a clean ongoing charges figure (OCF) of 1.05 per cent.