Are you a kid or do you wear big boy pants? As for our money, our guardians are not sure. On the one hand, governments force us through the tax system to save a few pennies throughout our working lives. We can’t be trusted not to blow them up on candy.
On the other hand, in the UK for example, we can withdraw a full quarter of our pension tax-free at age 55 – three decades before most of us die. Book this cruise! We can also use this money to play with the dangerous 300% Inverted Emerging Markets ETFs.
Regulators are confused too. When I was writing research for banks, I had to make sure my content was understandable even to retail clients who could barely read. Meanwhile, children around the world have been allowed to transfer their entire piggy bank to cryptocurrencies.
I was thinking about this recently when former colleagues were discussing inflation protected bond funds in our WhatsApp group. It’s hard to find a more adult (or sad) person. However, we struggled to understand much of the fine print. What hope do inexperienced savers have?
This is a good time to ask the question as global inflation remains elevated. UK readers also have until the end of the month to invest their annual Isa allowance. Should we all be spending our lunch money on inflation-protected bonds?
It was possible to ask this question also in 2021. Concerns about inflation grew. Geopolitical as above Low-risk government bonds certainly made sense, especially if you could realistically protect coupons and capital against losses.
Indeed, Treasury Inflation Protected Securities (Tips) – or indexed gilts in the UK – were traded as the preferred risk-free asset. According to Lipper data, in the United States, in the first three quarters of 2021, Tips funds received almost twice as much money as a year earlier.
In the UK, meanwhile, so-called linker funds have attracted nearly half a billion pounds in additional net assets by 2021, Morningstar estimates. In the second half of the year, searches for indexed bonds on Google were twice as high as usual.
What happened next? Tips have lost between 10 and 30 percent of their value over the course of 2022, depending on the securities held. UK index funds fared even worse. Crying was heard. It’s not fair! Inflation went up just like we thought!
It wasn’t a wrong sale. However, I bet that in their rush to hedge against rising consumer prices, investors paid much more attention to the term “inflation-protected” in the name of these funds than to the word “bond.”
That’s the problem. Tips and the like are basically two things at once. They actually help protect against inflation by adjusting the money investors get back when the bond expires. Coupons are similarly modified.
But they are still bonds. Which means prices fall when yields rise because coupon payments are fixed (regardless of inflation adjustment). Therefore, if there is a large increase in interest rates, bond yields are less attractive and the entire cabodel falls in value.
In other words, these bonds are exposed to changes in real interest rates, which have skyrocketed in the past year. UK funds are particularly vulnerable as they tend to hold bonds with maturities of less than 20 years, which is more than double the average duration of Tips.
It is these long maturities that make inflation-protected bonds so attractive to retirees and insurers who need to cover liabilities in the distant future. But keep in mind that the main inflation adjustment happens when these bonds buy up. This means that protection does little in the short term.
The problem is that inflation expectations If immediately discounted prices. This is why long-maturity funds were pounded last year. Everyone feared that central banks had left it too late to bring prices back under control.
What now? These things have gone down a lot. The way I look at them is that I first ask if I’m willing to lose my interest rate point shirt. (If not, there are products called “break-even” inflation funds. They allow me to check inflation without risking the interest rate.)
I digress – there are better hedges against inflation anyway. But that’s a different column. The next question is how much do interest rates have to go up before I lose money? To answer this question, compare the return of a protected fund with an equivalent unprotected fund.
If both have a duration of, say, 10 years and the difference is 3 percent, this “break-even” suggests that the market is pricing in 3 percent annual inflation through 2033. In other words, you give up 3 percent of the profit will be fully returned when the bond expires.
Buy a protected fund if you think inflation will exceed 3%. If you think lower, choose a vanilla fund. This assumes everything else is equal. it will not. Therefore, you also need to decide whether real interest rates are going up or down. Will rates go up or down more or less than inflation goes up or down?
I’m a cynical bastard when it comes to central banks. My money is bottling them, so the real rates are probably near the top. Despite Jay Powell’s hawkish testimony this week, Wall Street will put pressure on the Federal Reserve not to raise interest rates too much as they always do.
And in the UK, where we are still considered children when it comes to housing, I think there is a risk that the Bank of England will collapse in the face of lower house prices and not raise interest rates enough. I think you will soon see inflation-protected bonds in my portfolio.
The author is a former portfolio manager. E-mail: email@example.com; Twitter: @stuartkirk__