Three bond strategies to combat inflation

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Inflation dominated the financial markets in 2021 and is likely to remain a key driver of returns in 2022. For bond investors, there is no all-around protection against inflation, says mark holman of twentyfour asset management. It is impossible to completely exclude duration risk from a portfolio, he says.

In its annual analysis of investment forecasts from 46 of the world's largest investment banks and asset managers, bloomberg news counted the keyword "inflation" 224 times. "Covid," on the other hand, came up only 26 times. "The study concluded that rising prices drove nearly every scenario considered by strategists," says mark holman, partner & portfolio manager at twentyfour asset management, a vontobel asset management boutique.

In 2021, when economies around the world were recovering from the pandemic-related lockdowns in 2020, there was still debate about the extent to which inflation was temporary. With the data at the end of the year, this question seemed to have been settled. In november, the U.S. Consumer price index (CPI) was 6.8%, above 5% for the seventh consecutive month. The U.K.'S KPI hit a 10-year high of 5.1%, and germany's 5.2% – the highest since 1992.

Consumer price inflation vs. Vj. (%) – U.S., germany, U.K

"The well-known maxim that inflation is bad for bonds is based in part on the fact that inflation reduces the value of coupon payments and the principal that fixed-income bondholders get back. From a portfolio management perspective, the bigger challenge with rising inflation is that it typically leads to interest rate hikes, which in turn can have consequences for all bond segments – from U.S. Treasuries to high-yield to emerging market bonds," holman said.

The negative impact of inflation on some bonds is indisputable, he said. In his view, active fixed-income fund managers, who can draw from a global bond market of more than 120 tri. Scoop USD, but contain the impact of inflation with the right strategy. That's why the experts at twentyfour asset management see a number of return opportunities even in this environment.

Keep duration low

As holman further explains, price increases are usually associated with losses in government bonds, such as U.S. Treasuries, which in turn can result in losses in corporate bonds whose yield spreads to benchmarks ("spreads") are too narrow to compensate for weakness in government securities. This, he says, is the biggest inflation concern for fixed-income investors.

Investors became abruptly aware of this risk in the first week of the new year, when yields on 10-year U.S. Treasuries shot up to a nine-month high of 1.73%, he said. Minutes from the U.S. Federal reserve's december meeting had suggested that rate hikes could come sooner than the market had priced in. "In our view, this development is still in its early stages. With the U.S. Unemployment rate falling to 3.9% in december and inflation at its highest in 40 years, the conditions are clearly in place for the fed to start tightening. The central bank is facing a tightrope act," holman points out.

To counter inflation with bonds, twentyfour asset management's strategy is therefore to keep duration low in the first instance. Part of this, he said, was through portfolio construction, for example, by excluding longer-term government bonds and using bonds with shorter maturities for liquidity purposes. However, the experts are convinced that yield curves will rise, and therefore believe hedging interest rate exposure where appropriate is a sensible solution, as it is relatively cheap to do so. "Our preferred hedge curve would be sterling because of the low "carry" costs and given the increase in yields we expect on 10-year U.K. Government bonds ("gilts") to 1.4% by year-end. The euro curve would be a good alternative, but it is less attractive in our view," holman notes.

Floating rate bonds

There is no all-around protection against inflation for bond investors, he said. It is impossible to completely eliminate duration risk from a portfolio (as long as you are betting on assets that may be. Are still profitable). Inflation-linked government bonds such as US TIPS are less effective than expected, he said. The tactical interest rate swaps mentioned earlier may offer some protection against rising yield curves. However, in the opinion of the portfolio manager, they want to be used in a well-dosed manner, as an interest rate hedge can quickly become the dominant position in a portfolio.

"Our second strategy is therefore to consider floating rate bonds, which do not expose a portfolio to additional interest rate risk, as their coupons always rise in tandem with policy rates," holman said. He believes this should also have a supportive effect on leveraged loans, as well as the overall european asset-backed securities (ABS) market. For investors looking to benefit from the performance of these two sectors, he says european collaterized loan obligations (clos) will be the first choice in 2022, with the best results likely to be found at the lower end of the rating spectrum. BB-rated european clos could yield around 7% this year, largely consisting of the high "carry" available here.

Focus on yield and roll-down

The third strategy is to focus on yield and roll-down. Yields may prove to be one of the most effective weapons in the fight against inflation, holman further explains. It serves to cushion the loss of value in a portfolio due to rising interest rates, he adds. On the other hand, roll-down – the natural tightening of spreads on maturing bonds – can significantly reduce duration risk in a portfolio, he said.

Evidence suggests that the ongoing bull market in risk assets overall since the height of the pandemic about 18 months ago has made yields in many sectors of the bond market look expensive relative to prices in the past. But given the extremely robust fundamentals, the experts at twentyfour asset management believe this is justified. They also continue to identify untapped niches with value potential.

In addition, this year they are prioritizing subordinated bank bonds – or more precisely, so-called additional tier 1 (AT1) bonds – issued by european banks. Banks tend to be better protected against inflation than other sectors and tend to benefit from rising interest rates, it said. Moreover, banks proved their resilience during the 2020 crisis when they were able to maintain or even increase their capital base despite the difficult economic environment. "Currently, we see a large number of well-capitalized institutions with AT1 bonds that promise solid returns. If, for example, BBB-rated AT1 bonds were to come to market now, an issue from an A-rated bank with a five-year call option is expected to yield close to 5%," holman says.

"In our view, emerging market hard currency corporate bonds could also significantly outperform the market this year as they look to catch up with developed markets in terms of growth and returns. However, this opportunity could quickly pass if the fed tightens at a faster pace than previously stated," the portfolio manager adds. According to twentyfour asset management's annual outlook, this is not an investment option for the first quarter. The market reaction to the fed meeting minutes mentioned above may have already confirmed this view. However, given the 7.4% index return on emerging market high yield bonds, there are opportunities for patient investors with the right timing.

Defensive tactics

On the subject of roll-downs, experts say this defensive tactic makes the most sense when markets are well valued, which is usually in the mid-to-late cycle phase. At the beginning of a business cycle, most assets appear cheap relative to historical averages. "Then we would typically consider bonds with longer maturities rather than longer maturities to secure higher returns over the longer term. In terms of bonds, however, it seems that we have already reached the halfway point of the cycle, and over the past 18 months, bond curves have flattened at the long end. As we enter the next phase of this rapidly advancing cycle, we may now see a steepening at the short end in the face of priced-in interest rate hikes. We therefore expect short-term bonds – especially those with maturities of three to five years – to provide investors with the highest roll-down gains. Note, however, that the focus on roll-down at the short end of the curve is only really effective if bond spreads are sufficient to absorb the expected interest rate increases," says holman.