Boy or man, I’m into inflation-protected bonds

Are you a baby or do you wear big-boy pants? When it comes to our money, our guardians aren’t sure. On one hand, governments force us via the tax system to put some pennies aside throughout our working lives. We cannot be trusted not to blow them on sweets.

On the other hand, in the UK for example, we can withdraw a whole quarter of our pensions tax free at age 55 — three decades before most of us die. Book that cruise! We can also use the money to play with dangerous 300 per cent inversely geared emerging market ETFs.

Regulators are confused, too. Back when I wrote research for banks, I had to ensure my content was comprehensible even to retail clients who could barely read. Meanwhile, kids everywhere were allowed to tip their entire piggy banks into crypto.

I was pondering this recently as ex-colleagues were discussing inflation-protected bond funds on our WhatsApp group. You can hardly get more grown-up (or sad). Yet we struggled to understand much of the small print. What hope do inexperienced savers have?

It’s a good time to ask as global inflation remains elevated. British readers also have until the end of the month to invest their annual Isa allowance. Should we all be spending our lunch money on inflation-protected bonds?

One might have asked this in 2021, too. Inflation fears were building. Geopolitical ones ditto. Low-risk government bonds surely made sense, particularly if you could shield the coupons and principal from losses in real terms.

Indeed, Treasury inflation-protected securities (Tips) — or index-linked gilts in the UK — were being sold as the risk-free asset of choice. In the US, almost double the money poured into Tips funds in the first three quarters of 2021 than the year before, according to Lipper data.

In the UK, meanwhile, so-called “linker” funds had attracted almost half a billion pounds of additional net assets through 2021, reckons Morningstar. By the second half of the year, Google searches for index-linked bonds were twice as high as usual.

What happened next? Tips lost between 10 and 30 per cent of their value over 2022, depending on the securities they held. UK index-linked funds did even worse. You could hear the wailing. It’s so unfair! Inflation went up, just as we thought it would!

This was no mis-selling. But I’ll bet my horse that in a rush to hedge against rising consumer prices, investors paid way more attention to the term “inflation-protected” in the name of these funds than the word “bond”.   

Therein lies the problem. Tips and the like are essentially two things at once. They do indeed help protect against inflation by adjusting the money that investors get back when the bond expires. Coupons are similarly tweaked.

But they are still bonds. Which means prices fall when yields go up because coupon payments are fixed (notwithstanding the inflation adjustment). Therefore, if there is a big rise in interest rates, the yield the bond offers is less attractive and the whole caboodle falls in value.

In other words, these bonds are exposed to moves in real interest rates, which last year skyrocketed. UK funds are especially sensitive because they tend to own bonds which don’t mature for up to 20 years, more than double the average duration of Tips funds.

It is these long maturities which make inflation-protected bonds so attractive to pensions and insurers, who need to cover liabilities far into the future. But remember that the main adjustment for inflation happens when these bonds redeem. This means that, in the short term, the protection doesn’t help much.

The trouble is that inflation expectations are discounted in prices immediately. Which is why funds with long durations were hammered last year. Everyone feared that central banks had left it too late to bring prices back under control.

What now? These things have fallen a lot. The way I look at them is to first ask whether I’m willing to lose my shirt with a punt on interest rates. (If not, as it happens, there are products out there called “break-even” inflation funds. These allow me to make a call on inflation without the rate risk.)

A risk in my view is that the Bank of England folds in the face of weaker property prices and won’t increase interest rates enough

I digress — and there are better inflation hedges out there anyway. But that’s another column. So the next question is: how much do rates need to rise before I lose money? To answer this, compare the yield on a protected fund with an equivalent non-protected one.

If they both have a duration of say, 10 years, and the gap is 3 per cent, this “break-even rate” suggests the market is pricing in 3 per cent annual inflation to 2033. In other words, you are forgoing 3 per cent of yield to be fully reimbursed when the bond expires.

Buy the protected fund if you think inflation will be more than 3 per cent. If you think lower, pick the vanilla fund. This assumes all else is equal. It won’t be. Thus you must also decide if real interest rates are heading up or down. Are rates going to rise or fall more or less than inflation will rise or fall?

I am a cynical sod when it comes to central banks. My money is on them bottling it and thus real rates are probably near their peak. Despite Jay Powell’s hawkish testimony this week, Wall Street will put pressure on the Federal Reserve not to raise rates too much — as it always does.

And in the UK, where we’re still considered babies when it comes to housing, a risk in my view is that the Bank of England folds in the face of weaker property prices and won’t increase rates enough. I think you’ll see some inflation-protected bonds in my portfolio soon.

The author is a former portfolio manager. Email: stuart.kirk@ft.com; Twitter: @stuartkirk__