Inflation: is it all bad news for bonds?

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February 2022
 

Rising interest rates and growing inflationary pressures present both opportunities and threats to fixed-income investors as they gear up to invest more responsibly in a post–pandemic world, says Insight Investment portfolio manager Adam Whiteley.

After years of low inflation and low interest rates, is the inflationary curse that plagued global markets in the 1970s and 1980s now back to haunt us? And with the US and UK inflation rates recently jumping to their highest levels in almost 30 years1, and further energy and cost of living price rises looming, just how bad is the picture for fixed-income investors?

For Insight Investment portfolio manager Adam Whiteley, the current inflation scenario in markets such as the US present both opportunities and threats for investors.

Outlining some key factors driving the recent inflationary trend, Whiteley says:

“Rising inflation today is a consequence partly of supply bottlenecks as we exit the Covid-19 pandemic with too little goods and services to meet the level of demand. Inflation is also on the increase because we have labor markets that have now almost fully recovered from the losses that we saw in the early stages of the pandemic—with the workforce starting to gain greater bargaining power over wages.”

Commenting on the knock-on effect of inflation—and resulting central bank action to raise interest rates—Whiteley believes investors could, paradoxically, benefit from looking beyond traditional fixed-income products, such as inflation-proofed bonds, to find value elsewhere in the market.

Inflationary threat

“Inflation is something central banks will always target and will look to reduce from high levels, most likely through greater interest rates, but also the withdrawal of some of the type of extraordinary support, such as quantitative easing, we saw throughout the pandemic,” he says.

“That means investors need to be mindful around the interest-rate sensitivity. Intuitively, it might seem to make sense to consider inflation-protected bonds, but they are arguably already expensive to buy in today’s market. Instead, we believe strategic bond investment can help seek out risk-adjusted income and deliver potentially more opportunity.”

While Whiteley has seen a substantial recovery in credit-market valuations from the lows seen at the height of the pandemic, he believes, arguably, that the biggest risk to markets is a material rise in government bond yields. Against this backdrop, he suggests areas such as high yield and emerging markets could offer positive potential in 2022.

Responsible investment

While fixed-income investors work to defend themselves against the dual threat of higher inflation and interest rates, many also are looking to invest more responsibly, taking environmental, social, and governance (ESG) factors into greater account as the pandemic dissipates, he notes.

For Whiteley, fixed-income investors can support sustainable outcomes through several different routes, such as directly stepping up efforts to reduce the environmentally or socially negative impacts of their asset allocations or investing in so-called labeled bonds, which are designed to fund environmentally or socially responsible projects. However, he adds that such investments should be carefully vetted to avoid so-called “greenwashing,” whereby companies deliberately convey a false impression about the strength of their environmental credentials.

“While investors can gain exposure to several bonds which fund worthwhile projects of real benefit to the environment and the social good, it is always important to study their underlying documentation carefully to see whether the framework itself for that green bond allocation is credible and that the use of proceeds is very clear. It is also important that the issuers have strong ESG profiles and are really encouraging best practice,” he concludes.

1 Guardian, “UK inflation rises to highest level in nearly 30 years,” January 18, 2022.; “Pressure on Fed to raise rates as US inflation surges to 30-year high,” November 10, 2021.

 

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