MetAM forecasts show that inflation should reach the bottom of the current cycle in the third quarter of this year. This is good news for inflation-linked bonds. Real yields (income returns) on inflation-linked bonds tend to move with the inflation cycle.
As inflation trends upwards, investors look to assets that will shield their capital from the eroding effect inflation has on real returns. This means a preference for inflation-linked bonds since this bond compensates investors for higher inflation. This higher demand pushes the price of the bond higher, providing a capital return.
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.
But there is now 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. These bonds are becoming increasingly popular in the current inflation cycle.
Having 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. It is difficult for individuals to purchase inflation linked bonds directly so one can invest in a unit trust such as the Metropolitan Inflation-Linked Bond Fund which recently won the Morningstar Category Award for best returns over a three-year period has returned 10,21% annualised over the past five years and 9,59% annualised over the past three years to December 31 2009.
Deon Van Zyl is a portfolio manager for Metropolitan Asset Managers.
Read more news, blogs, tips and Q&As in our Smart Money section. Post questions on the site for independent and researched information.