Despite the risk of higher interest rates amid high inflation, the firm says markets are underpricing the likely inflation path, making inflation-linked bonds relatively cheap – at least for now.
While inflation is not typically ideal for bond investing, FIIG Securities head of research Phillip Brown says there are options that offer either direct inflation protection or indirect protection through exposure to floating interest rates.
His comments follow a sharp acceleration in Australia’s inflation in March, with annual CPI rising to 4.6 per cent from 3.7 per cent in February. The fuel-driven surge in headline prices has reinforced expectations that the Reserve Bank of Australia (RBA) will raise interest rates again this month.
This would be the third hike this year, following RBA increases in February and March, taking the cash rate to 4.1 per cent.
For an environment where a “higher inflation for longer” profile is a material risk, Brown argued there should be an increased desire for other types of bonds, in particular floating rate notes (FRNs) and inflation-linked bonds.
But as he noted, the “key question for investment” is always to look at what the market is pricing in, and he said there is now an imbalance that looks attractive for investors.
“We think the market is under-pricing the likely path of inflation. In other words, buying inflation insurance in the form of inflation-linked bonds is currently quite cheap. Given the very real possibility of a sustained rise in inflation, now is an excellent time to purchase inflation protection,” Brown said.
As he explained, bond yields have already risen alongside inflation expectations. Just as interest rate markets move ahead of expected RBA decisions, inflation markets price in future data, but they are imperfect and prone to bias.
“We can’t know whether current inflation expectations are correct until afterwards, of course, but we can check how the inflation markets performed during the outbreak of inflation in 2022.”
At the start of the inflation surge in 2022, Brown noted that markets underestimated how high inflation would go and how long it would persist. As a result, investors who shifted into inflation-linked assets early could have outperformed those who stayed in nominal bonds.
At the same time, Brown also cautioned that while inflation-linked bonds offer a form of inflation protection, they are still bonds at the end of the day and carry inherent risks.
In particular, some inflation-linked bonds run out to 30 years. While they can be effective for hedging long-term inflation, they are not suitable over shorter horizons of two or three years.
“Over the full 30-year term, these “linker bonds” perfectly hedge inflation, but over two or three years, the impact of CPI indexation is quite small, while the impact of changes in interest rates can be very large. That makes them inappropriate for investors who have a short or even medium-term investment horizon.”
But that also creates opportunities, as many of these long-duration bonds are held by asset-liability matchers such as life insurers. He said this leaves scope for other investors to pick up shorter-dated “linker” bonds at attractive prices.
Brown’s comments also follow FIIG’s January bond allocation strategy in the context of potential interest rate rises, which he said is now even more relevant given Australia’s inflation backdrop and the added inflationary pressures stemming from the Iran war.
One of the “most obvious” candidates of bonds providing inflation protection, according to the firm, is the Sydney Airport Nov-30.
“As an inflation-linked bond with only a 4.5-year maturity, it is very well suited to investors who are worried there might be a burst of inflation in the coming years. The Sydney Airport line is one of the few inflation-linked bonds issued by someone other than a government, which means clients receive a credit spread, too. At present, this bond is offering a yield of around CPI + 3.31 per cent,” Brown concluded.
