Inflation-linked bonds: Rally imminent as inflation nears the bottom

Including inflation-linked bonds in a portfolio is an excellent way to mitigate inflation risk. They are suitable for both individual and institutional investors as part of a diversified portfolio or a hedge against inflation.

Inflation-linked bonds are favourable from a buyer’s point of view, since the investment is protected against unexpected increases in inflation. When inflation risk - the unanticipated change in purchasing power - is present in the case of a conventional bond, the issuer will need to compensate the buyer for this risk with a higher yield. Therefore, inflation-linked bonds generally have lower borrowing costs than conventional bonds. Issuers of inflation-linked bonds are also protected against a downside surprise in inflation.

Growing popularity

These bonds are becoming increasingly popular in the current inflation cycle. MetAM forecasts show that inflation should reach the bottom of the current cycle in the third quarter of this year, implying that a rally in inflation-linked bonds could be imminent.

With current yields on the R197 at around 3.3%, 75 basis points higher than last year’s low point, inflation’s gradual upward trend is anticipated from the middle of the year onwards. This is likely to trigger a marginal market preference for inflation-linked bonds compared to conventional bonds, pushing prices higher.

The inflation link

Real yields on inflation-linked bonds tend to move with the inflation cycle. As inflation trends upwards, investors seek to shield their capital from the eroding effect rising prices have on real returns. Subsequently, marginal preferences for inflation-linked bonds increase, since this bond type compensates investors for higher inflation. This higher demand usually leads to somewhat compressed returns (lower real yields) on these bonds, which in turn means higher prices.

The converse is also true. When inflation is on a downtrend, a higher return can be generated by investing in conventional bonds, where the “priced in” inflation risk premium of these bonds are likely to overshoot the actual downward-moving inflation trend and investors face a smaller probability of having real returns eroded, due to the lower inflation. This higher demand for conventional bonds versus inflation-linked bonds sparks a sell-off in the latter again.

This implies that as inflation reaches its peak, inflation-linked bonds will start to sell-off. We have been experiencing such a sell-off since inflation reached its peak at 12% year-on-year (y/y) in August last year.

Energy security factor

But there is pressure on price levels (most noticeably from the energy sector). While electricity constitutes a small portion of the inflation basket (1.68%), the successive “shocks” of 20%+ tariff increases in the inflation basket will inadvertently increase its effective weighting in the inflation basket. Considering the uncertainty around energy security, it’s uncertain as to what extent and for what period of time energy prices will increase.

Furthermore, in addition to the primary effect on prices, consecutive energy price shocks will also potentially have sizeable second round effects on inflation. It is worth noting that while consumers only constitute 15% of South Africa’s energy demand, much of the price increases borne by the industry will either be absorbed or, more likely, passed on directly to consumers.