Linker bonds: inflation-proof or inflated expectations?

FILE PHOTO: People are seen on Wall St. outside the NYSE in New York
FILE PHOTO: People are seen on Wall St. outside the New York Stock Exchange (NYSE) in New York City, U.S., March 19, 2021. REUTERS/Brendan McDermid/File Photo

June 3, 2021

(Removes erroneous reference in para 20 to Columbia in Candriam’s overweight positions)

By Dhara Ranasinghe and Abhinav Ramnarayan

LONDON (Reuters) – Investors are piling into bonds offering protection from rising consumer prices as they brace for the strongest period of global inflation in more than a decade, but could the market be overplaying the risk of a price surge?

U.S. breakeven rates, which reflect bond market inflation expectations, signal inflation in the years ahead of 2.4%-2.6% in the United States, sparking demand for U.S. Treasury Inflation-Protected Securities (TIPS).

Inflows of $2 billion during the week to May 19 were the largest in 24 weeks, according to BoA, following the previous week’s $1.9 billion inflow.

Breakeven rates in Britain and the euro zone too have soared to the highest since late-2019 and late-2018 respectively.

It’s a potent warning from the $3.6 trillion global inflation-linked debt market, where bonds are often called “linkers”.

But not everyone buys it.

Guneet Dhingra, Morgan Stanley’s head of U.S. interest rates strategy, says current pricing — even if one takes an upbeat view of U.S. inflation — is closer to reflecting hysteria than optimism.

Dhingra cited five-year U.S. breakeven rates, which recently hit a 10-year high around 2.76% and are currently around 2.63% or 263 basis points.

“Inflation risk premiums over the last 15 to 20 years have tended to move in a range and when you get to the 260 bps area, that’s roughly a peak for the inflation risk premium,” he said.

“So, any move above the 260-265 bps area suggests we’re getting into the hysteria zone.”

Stimulus pumped in to counter economic damage from the pandemic is one factor behind rising inflation.

U.S. consumer prices rose 4.2% in the year to April, the largest gain since September 2008, UK inflation doubled to 1.5% in April from March, and euro zone inflation surged past the European Central Bank’s close to 2% target last month.

Investors favour linkers at such times because the principal and interest payments rise and fall in line with inflation over the life of the bond.

But central bankers remain calm, pointing to one-off factors and not expecting the inflation surge to last.

Oxford Economics analyst John Canavan says that limited TIPS supply is helping compress TIPS real yields, while nominal yields are rising in response to stronger economic growth and inflation, exaggerating the rise in breakeven inflation expectations which are based on the difference between the two rates.

The $1.6 trillion TIPS market as a share of outstanding marketable debt has fallen to just 7.3% – the lowest since September 2011, Canavan noted.

Short-dated TIPS do have a record of overshooting inflation, noted Mike Kelly, head of multi-asset at PineBridge Investments. He is particularly wary on inflation-linked bonds out to three years, seeing the overshoot there at 50 to 80 bps.

Still, many investors are unconvinced by central bank assurances that the current inflation upsurge is transitory.

“We have seen a peak in terms of globalisation – and that will impact inflation because production will no longer be so cheap,” said Amundi’s head of investment absolute returns Cosimo Marasciulo, who holds linkers.

Sylvan de Bus, deputy head of global bonds at asset manager Candriam, which has an overweight allocation in U.S., euro zone, Canadian and Mexican linkers, said that despite base effects and index weight adjustments, “it is undeniable that there is an overall picture of economic recovery”.

CALCULATIONS

The demand/supply distortion is highly pronounced in Britain, where structural pension fund demand has crushed ten-year linker yields to -2.7%, well below Germany’s at -1.5%.

The difference is partly because UK linkers are pegged to retail price inflation (RPI), which is typically a full percentage point higher than the consumer price inflation (CPI) targeted by the Bank of England.

Britain plans to overhaul RPI in 2030 to bring it close to CPI, which analysts say could forcibly reprice linkers by up to 50 basis points.

That’s one reason to be cautious on inflation-linked Gilts, PIMCO portfolio manager Lorenzo Pagani said.

In the euro zone, 10-year breakeven rates have risen 40 bps this year to 1.4% but inflation isn’t expected to settle around the ECB’s 2% target for years.

“The dichotomy between current inflation and market-based inflation expectations is even stronger than in the U.S.,” said Societe Generale senior rates strategist Jorge Garayo.

If breakevens continue rising at the same pace, linkers could soon start to overstate the case for European inflation, he reckons.

HOLD TO MATURITY

Forecasting inflation is notoriously tricky and even central banks often get it wrong, as Amundi’s Marasciulo noted, so some overshoot by linkers is unsurprising.

But longer-dated TIPS have closely tracked inflation’s trajectory over the years and PIMCO’s Pagani is one investor who considers linkers an “excellent inflation hedge” — unlike gold or real estate, they are designed expressly for that purpose.

Others have their own strategy. Jim Caron, portfolio manager at Morgan Stanley Investment Management sees TIPS as an “inflation hedge full stop” but only when held to maturity.

Instead, he holds TIPS tactically, preferring to “underweight 10-year Treasuries or buy cyclical assets that benefit from higher yields” to guard against inflation.

(Reporting by Dhara Ranasinghe and Abhinav Ramnarayan; Editing by Tommy Wilkes, Sujata Rao, Kirsten Donovan)