Inflation-linked bond funds recorded net inflows of €3.3bn in the month before the US presidential election, according to Morningstar data, dwarfing the previous all-time record of €1.4bn set in April 2011. This unprecedented interests in inflation-linked bonds has of course been driven by the uptick in inflation expectations, especially in the US and the UK, but also in the Eurozone.
As five-year break-even yields have risen from 1.3% to 1.85% since July, however, some investors believe the market has already priced in the expected rise in inflation. “Break-even yields have risen very quickly. In just two months, we’ve seen a rise of 30 to 40 basis points,” says Laurent Truchi, head of fixed income fund selection at Edmond de Rothschild in Geneva.
But Jonathan Baltora, manager of the AXA WF Global Inflation Bonds fund, the largest inflation-linked bond fund available for sale in Europe, believes inflation has further to go, especially in the US. “I just came out of our quarterly forecasting session, and we believe that inflation in the US will rise to 2 to 2.5% in five years. As the current break-even yield is at 1.85%, this means there is some additional carry available,” he says.
Baltora believes that, while the recent OPEC decision to cut oil production has provided a backstop to oil prices reducing downside risk for inflation, the presumed policies of Donald Trump will especially boost inflation. “The introduction of extra tariffs on imported goods and his fiscal spending proposals would support prices,” he says. “And the third point is the job market. Wage growth is accelerating and is now already at similar levels as in 2008. If Trump limits immigration, this would lead to a tighter labour market and push wage growth up further.”
The outlook for inflation may suggest inflation-linked bonds are a compelling investment opportunity, but history has shown that the best returns from inflation-linked bonds have in fact come during deflationary periods, because of the dominance of the duration component in returns.
That’s exactly the point Joachim Klement, head of thematic research at Credit Suisse AM, wants to make. The choice between inflation-linked and nominal government bonds is basically one between a sour and a rotten apple, he claims, concluding: “It doesn’t make a lot of sense to own any government bonds if you don’t need to.”