Why inflation matters for your portfolio

Inflation has been such an important talking point in global markets over the last decade. Whether it has been the specific targeting of higher inflation under the Japanese policy of Abenomics, the threat of deflation in Europe or the lack of wage growth inflation in Australia and the US. Yet, even as central banks around the world have flooded asset markets with unprecedented and extraordinary amounts of liquidity, higher inflation, over 3% for instance, has yet to return. Is it just a matter of time?

We are sure most of our readers understand the concept of inflation, in that it reflects the general rise in the prices of goods and services in an economy. However, we aren’t confident that a lot of investors understand how much of an impact it can have to their portfolios over the long-term and why it should be an important consideration for their investment strategy. This is particularly relevant for SMSF trustees and retirees who effectively require a certain and growing income stream throughout their retirement to fund real and increasing expenses.

In order to account for the long-term effects of inflation, investors need to focus on the ‘real’ return they receive from their investments i.e. the return adjusted for inflation. Consider for instance the situation where you are investing into a 3-year term deposit paying interest of 2.5%. If inflation is 2.1% per annum, the after inflation return, or what you can spend, is just 0.4%. If the funds were held in a cash account at  1.5%, the  after-tax   return  is  negative,  at -0.6%. This has been one of the driving forces behind today’s bull market run as investors have been forced to  take  more  risk in order to deliver  positive  real returns for their clients.

Hedging against inflation

For many years there has been an expectation that the likes of property, gold bullion or equity markets, through their  connection to  the  economy,  would  actually  provide a hedge against inflation. Many believed that they would simply be able to increase their profits and cash flow to deliver higher returns to investors. Unfortunately, in the real world this has generally not been the case. One of the most well-known investors in the world when it comes to assessing and protecting against inflation is Bridgewater Associates, which is run by billionaire Ray Dalio. Bridgewater have advised some of the world’s largest pension funds about how they can most effectively manage the risk associated with the pension liabilities against the threat of increasing inflation; which in their cases can be disastrous.

Through their many decades of experience, Bridgewater have built some of the most complex models to explain how as they call it ‘the economic machine’ actually works. One of the most relevant for the purpose of this report, is their work on how various asset classes react in the four main economic environments, being:

  • Rising economic growth
  • Falling economic growth
  • Rising inflation
  • Falling inflation

As you can see from the series of tables, the long-held assumption that equities provide a hedge against inflation simply does not hold up. In fact, the data confirms that equities perform most strongly in periods of rising growth and falling inflation and tend to deliver negative returns when inflation actually increases. Conversely, Government and other bonds perform well when growth is falling, and inflation is falling, as this is usually associated with interest rate cuts. This leaves only two main asset classes that offer protection when inflation is rising, inflation- linked bonds and commodities.

What are inflation linked bonds (ILBs)?

The most common inflation-linked bond is the ‘capital indexed bond’ or CIB. Under the terms of these bonds various in inflation are added and subtracted from the capital price of the bond. For instance, if the issue price of the bond is $100 and inflation in year 1 is 3%, the value of the bond at the end of Year 1 will be $103. This is known as the adjusted capital price or value. Importantly, it isn’t solely the capital value that is changed if inflation rises, the coupon or interest payment, which is typically a fixed percentage, is reapplied to the adjusted capital value for each payment. Using the previous example, if the coupon was 3%, then the interest payment in year 1 would be $3 and in year 2 it would be $3.09 ($103 * 3%).

ILB’s may sound like complicated instruments, however, they are no different to a typical Government bond. They have actually been around since the 1700’s but given they could represent a growing liability to Governments seeking to increase inflation, there issue has not been widespread until more recently. In fact, some figures suggest the supply of ILB’s has increased tenfold in the last decade as investors sought additional security and Governments attempted to take advantage of a benign inflationary environment. Many believe this may be coming to an end.

 

A comparison of cash flows

In the table above, we have provided a real- world example (from Wrase, 1997) of how inflation-linked bonds operate and most importantly differ from a traditional or ‘nominal’ bond. For the purposes of the case study, the following assumptions have been used:

  1. A real coupon of 3% on the ILB;
  2. An inflation rate of 2% per annum over 10 years;
  3. A coupon of 5.06% for the nominal

As you can see from the table above, the inflation linked bond offers a consistent ‘real’ interest payment whilst the value of the higher nominal payment of the traditional bond reduces each year due to the impacts of inflation. More importantly, the value of the capital you will receive from the inflation linked bond, $1,218.9, is 22% higher than the traditional bond and more than enough to cover the lower nominal interest payments received during the period.

Why should they have a place in your portfolio?

In our view, all investors face three key risks when moving towards retirement: market; inflation and longevity. Against a backdrop of rising inflation and a transition towards lower risk asset allocations investors are decreasing their market risk and increasing the inflation and longevity risk associated with their portfolios. This is an interesting conundrum.

Whilst low-risk investments should represent a higher proportion of wealth as investor’s age, weight must be given to the future purchasing power of accumulated wealth and the need to ensure retirement capital grows at least in line with inflation. ILB’s represent an attractive solution. ILB’s allow investors to remove all market risk whilst hedging away the impacts of inflation over the long-term.

ILB’s provide a guaranteed real rate of return to investors. This means that the real return on an ILB remains the same throughout the life of the investment. It is important to note, however, that the fixed rate nature of the interest payments on ILBs means that they can subject to similar interest rate risks to that of ‘normal’ bonds.

ILB’s are effectively a risk less asset in terms of preserving the real value of your capital and your future purchasing power. The evidence suggests that they provide a nearly perfect hedge against inflation and have a low correlation with almost all other asset classes, being the only investment that has consistently increased in value when inflation rises. They are by no means the perfect investment, for instance investors may lose capital in a deflationary environment, and they are subject to the standard credit and counterparty risk that comes with making any bond investment.

With inflation pressures expected to rise (they are actually being targeted) in Australia and the US and increasing allocations to low-risk investments, we believe every investor should consider the benefit and appropriateness of an allocation to ILB’s in their portfolio. If you are interested to learn how, please contact us.