We’ve finally made it.
I hope you’ve enjoyed the series so far. Now comes the tricky part of wrapping together what’s been a series of back-and-forth on the merits of inflation-linked bonds.
Before we look at whether they’re worth holding or not, let’s quickly recap where we’re at.
In the first post, we saw:
- The main difference between nominal bonds and inflation linked bonds is that inflation linked bonds are (surprisingly) linked to inflation.
- If inflation rises, the par value of the inflation linked bond will also rise. The coupon also increases with inflation since it’s based on a higher principal value.
- The difference between the yield on an inflation linked bond and the yield on a nominal bond with the same maturity is known as the breakeven inflation rate. This is the inflation rate where owning inflation linked bonds would provide you with the same real return as owning nominal bonds.
In the second post, we saw:
- There are 4 reasons why someone might want to own inflation linked bonds:
- Short term unexpected inflation protection – linkers have a very high correlation to unexpected inflation, and are one of the most reliable, safest choices for hedging inflation.
- To fund their spending – linkers are very useful for retirees whose spending is linked to inflation, and funded from their portfolio.
- Asymmetric return payoff – linkers offer unlimited upside in highly inflationary environments, with only limited downsides in less inflationary/deflationary environments. As an added bonus, the upside is absolute, but the downside is only relative.
- As a diversifier – linkers provide another source of crash protection when held alongside nominal bonds.
In the third post, we saw:
- Inflation linked bonds also have their fair share of drawbacks:
- Fund availability – UK linkers have a high duration risk, and global linkers are less relevant for the UK inflation rate.
- RPI relevance – the stats nerds at the ONS think RPI overstates inflation, and its use is being phased out.
- RPI is a single measure of inflation – it:
- Won’t match your personal inflation rate,
- Doesn’t account for inflation effects in product quality, or the substitution effect.
- Liquidity – index-linked bond funds trade slightly less than their nominal counterparts, but not by much. They’re also wrapped in an ETF vehicle which adds another layer of liquidity on the secondary market.
- Inflation protection and structural issues means lower yields – this is also a problem, but not one we’ll be able to solve. We’ll just have to trust that markets are efficient enough for linkers to be properly priced.
- Accumulators have a much lower need to be hedge short-term unexpected inflation.
- Price volatility – linkers, on the whole, have similar volatility to their nominal counterparts – especially when looking at UK funds. For global funds though, nominals do seem to have the edge with lower drawdowns.
So now we get to the pointy end of the series.
We’ve seen some surprisingly strong arguments for putting your entire bond allocation into inflation linked bonds.
And also some equally strong arguments for holding none at all.
So should we own them? And if so, in what circumstances? And how much of them should we allocate to?
Bringing it all together
The general rule of thumb for inflation-linked bonds is the more you rely on your portfolio for basic living expenses, the larger the portion of bonds should be in linkers. This rule of thumb is surprisingly under-followed, but we’ve seen the reasons why it makes sense.
Usually (but not always), this means the more you have in bonds, the larger the portion should be in inflation-linked bonds.
So an ideal inflation-linked bond allocation will end up looking like a glidepath.
In a magical world where passive short-dated UK government inflation-linked bond funds existed, my bond fund allocation would change through time. As a young investor with a high risk tolerance, I’d have no bonds. Then, as I started to introduce bonds into my portfolio, they’d mostly be in the form of nominals. Then as I get closer to retirement and move into retirement, my bond allocation would not only increase, but would shift more into inflation-linked bonds to fund my spending.
But unfortunately for us UK investors, there’s a snag.
Given the lack of short-duration inflation linked bond funds, our inflation protection comes at a heavier price than our lucky brethren in the US. If we want to buy anything other than ultra long-dated linkers, we have to sacrifice further on the relevance of the inflation measure. We’ve seen already how RPI is a pretty shabby measure for inflation as it is, and by better protecting ourselves against short-term inflation by reducing our duration, we’re increasing our weight to other countries’ inflation levels, which reduces the effectiveness of the protection even further.
Although the correlation between US inflation and UK inflation has been relatively high since the 80s, we can never rule out a huge inflationary spike like in the 70s, where inflation was not only extremely high, but much higher than in the US. In such an event, holding UK linkers would be far preferable to global linkers.
As a second annoyance, inflation-linked bonds are most useful for those who are using them to fund their spending – i.e. retirees drawing down their portfolio. But it’s the retirees whose personal inflation rates are going to look most different to the RPI, given how different their basket of goods is likely to be. Despite having a greater need for inflation protection, the benefit of that protection reduces as their spending changes in retirement.
Inflation-linked bonds become a less reliable proxy for personal inflation the further the investor gets towards needing to rely on them.
This problem is exacerbated by the lack of RPI-linked short duration bond funds. And if we’re using inflation linked bond funds to fund our spending, then we’ll need to keep duration nice and short. This means we’ll have to use global inflation linked bond funds, which have a much lower weighting to UK inflation rates.
So that’s a double whammy – when you need inflation protection most, your spending looks the most different to RPI it’s ever likely to be, and you’re also forced into using other countries’ inflation rates in order to keep your duration low.
So we have some trade-offs to consider.
Let’s summarise by taking some of the major grievances usually levelled against inflation-linked bonds:
UK fund availability: The lack of passive short-duration inflation-linked bond funds is a problem – there’s no getting around it. But when considering global inflation-linked bond funds, I think a 1970s perfect storm inflation event of ultra-high inflation and very different inflation to the US is unlikely. And even it did occur (we should always plan for the unexpected in our portfolios), then a) we’ll still be holding inflation-linked bonds, which will perform extremely well in such a highly inflationary environment, and b) as long we’re still holding a good portion of our linkers in RPI-linked funds then we’ll still be taking the worst of the sting out of the UK’s relatively higher inflation.
By accepting global inflation-linked bond funds, we’re able to broaden our universe of investable funds and mitigate some of the duration risks inherent in UK inflation-linked bond funds, at the cost of a less relevant measure of inflation.
RPI: Using a single measure of inflation isn’t ideal – especially something as flawed as RPI. But realistically we can never expect any single measure of inflation to perfectly match our own spending. And I think those in retirement who are most vulnerable to inflation are likely to be glad of having some inflation protection rather than none at all.
Liquidity: Unless investors suffer a lack of liquidity in the linker ETF and a lack of liquidity in the underlying inflation-linked bonds, then they should be OK from a liquidity perspective.
I’m not saying it can’t happen, and, in fact, the time it’s most likely to happen is when you need liquidity most – during a crash. But by holding your linkers in an ETF wrapper, you’re adding an extra layer of liquidity which reduces your illiquidity risk.
Price volatility: Really when it comes to volatilities, duration seems much more important than whether you’re opting for an inflation-linked bond fund or a nominal bond fund.
When push comes to shove, global nominals have an edge over global inflation-linked, but the volatility differences between UK linkers and nominals are marginal, when comparing funds with similar durations.
Would I own them?
Personally, I still like inflation linked bonds, for those who need them (which isn’t everyone).
On the downside, their drawbacks seem more like inconveniences, but on the upside, they come with some pretty attractive benefits. Namely:
- They’re one of the most reliable, safest choices for hedging inflation.
- They have an asymmetric return payoff (unlimited upside with inflation, limited downside with deflation), with the added attraction of being an absolute benefit on the upside (keeping up with unexpectedly high inflation), but relative on the downside (you’re only losing on a relative basis to nominal bond holders – you’re still able to fund your spending).
- They can act as a second source of diversification alongside nominal bonds. Their drawdowns tend to occur at different times, and both provide ample protection against market crashes.
Inflation-linked bonds tend to be overlooked, but allocating to them can make sense for those who rely more heavily on their bond portion of their portfolio to fund their spending. At the very worst they’re no worse than “suboptimal”.
If you could design a perfectly risk-free asset, it would look something like an inflation-indexed perpetuity with no default risk. And this sounds like inflation linked bonds to me. Linkers are pretty much as close to a risk-free asset as investors are likely to get.
Which is why I think it’s best not to think about them as outperforming/underperforming vs nominals depending on inflation, but instead as a tool to remove the risk of inflation. They’re the baseline which other assets (including other bond holdings) should be measured against.
In terms of how much I’d personally recommend allocating to inflation-linked bonds, it’s obviously hugely dependent on your risk profile and stage of life. I personally hold none, because I’m relatively young, and have a high risk tolerance. But if I were a retiree in drawdown, then I’d be more than happy with an allocation to inflation-linked bonds, as long as the level of duration was appropriate.
For those who are looking for more specific guidance, I’m hopefully going to be publishing my own set of model portfolios for subscribers in the coming months.
But whatever you think about inflation-linked bonds, an additional and (in my opinion) more important concept is matching the duration of your bonds to your investment horizon. Getting that bit wrong can be far more dangerous for your portfolio than a suboptimal mix between nominal and inflation-linked bonds.
Luckily for those who enjoy reading about bonds as much I enjoy writing about them (which is weirdly more than I thought), I’ve started putting pen to paper on a series all about the importance of duration-matching bonds. So expect that in your inboxes in the coming weeks.
Until then, though, I hope you’ve found this series on inflation-linked bonds useful. I’ve no idea why they’re so overlooked as an asset class, but hopefully this series has shed some light on a darker corner of the investment universe, and provided some food for thought as to whether they’re a worthwhile addition to your portfolio.