Softer economic indicators and hawkish signals from central banks have prompted market expectations of a pause in interest rate hikes. AXA Investment Managers point out that this shift raises questions about the implications for the inflation-linked bond asset class.
“Investor behaviour often means that inflation-linked bonds see strong inflows as inflation takes off and then sharp outflows when nearing the peak regardless of what the inflation level is,” writes Elida Rhenals, Portfolio Manager at AXA.
According to her, this trend has persisted in the current inflationary cycle. This is because investors have moved away from inflation-linked bonds toward the end of 2022 in anticipation of the peak in headline inflation.
However, the asset manager suggests that the challenge for investors lies in the fact that inflation remains high, even by historical standards, despite lower-than-expected outcomes in October 2023.
Rhenals informs that the persistence of inflation, potentially extending over the next decade, is influenced by factors such as the green revolution, onshoring trends, and concerns about budget deficits.
AXA also highlights that market conditions, such as an inverted yield curve, historically precede a yield rally, making a compelling case for duration. This expectation of a duration rally when core inflation recedes suggests an interesting opportunity for investors, adds the asset manager.
“Inflation-linked bonds’ average real yields are currently at their highest average level since 2009-2010, but they are positive, suggesting that investors can lock in an above-inflation income,” says Rhenals.
“With inflation likely to be volatile for the foreseeable future, inflation-linked bonds may be a useful tool for investors because they should provide resilience against sticky inflation,” she opines.
The asset manager asserts that the cash flows of all inflation-linked bonds are tied to inflation rates, and these bonds are typically issued by sovereigns with high credit ratings. Thus, Axa believes that incorporating investments in inflation-linked bonds can serve as a component of an investor’s strategy for preserving capital.
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