Should investors be worried about inflation?
There are certainly grounds for concern. Supply bottlenecks are multiplying across the globe, affecting everything from petrol to computer chips while the high levels of cash held by households and companies suggest consumers and businesses may be willing to accept higher prices in future. Then there's a tightening employment market. Labour shortages are occurring in many parts of the economy and wages are rising.
Yet, whether inflation will turn out to be temporary or become entrenched is far from clear. Some of the biggest banks in the world are taking opposing views – Bank of America has been piling money into longer-duration bonds, while rival JP Morgan Chase has opted to park its cash in deposits at the US Federal Reserve.1
There is little doubt, however, that the spectre of inflation is already sending shockwaves through global financial markets.
Inflation expectations, as measured by US 10-year break-even rates, are near their highest levels in eight years. Sovereign bonds in US, UK and the euro zone, as well as emerging market credit, have all lost money over the past 12 months, with returns eaten up by rising yields.
For investors worried about inflation, a knee-jerk reaction may be to reduce bond holdings. But bonds aren’t the only investments that will be affected. Indeed, history tells us that, if inflation proves sustained, most risky asset classes will suffer. And cash isn’t the solution, as its real value will also be eroded.
There is, however, one area of the market where investors can potentially find refuge from inflation worries – short duration bonds. It’s an asset class that has been largely overlooked for the past five or six years as most investors have been attracted to riskier assets and higher yielding debt. Now, it looks attractive once more.
There is a strong case for using short-term bonds as an insurance policy. To begin with, they are far less sensitive to interest rate rises than longer-maturity bonds.
The gap in duration between short-term and standard maturity bonds has grown to levels last seen 10 years ago, reflecting the fact that corporate and sovereign borrowers have taken advantage of low interest rates to issue ever longer dated debt. Taking global corporate debt as an example, the effective duration now averages at 7.4 years, versus 1.9 years for the short-term part of the market. The gap is two years longer than it was a decade ago.
A gap of that magnitude is significant as lower duration equates to lower volatility from interest rate fluctuations. Our curve steepening stress tests - which estimate the effect on bond prices from an inflation-induced steepening of the bond yield curve - show that our short-term strategies would be between 25 and 56 per cent more resilient to than their all-maturity counterparts.2
Based on current yields and duration, short-term bonds have a much greater cushion against rising yields. For example, returns from US high yield bonds will be erased once yields have risen by 100 basis points, while returns for short-term high yield will remain positive until yields rise by 240 basis points (see Fig. 1).Investors wanting to minimise risk as far as possible might consider money market funds, which focus on ultra-short duration bonds, with an average weighted maturity of well under a year.
The short-term credit universe, meanwhile, features a wide range of high quality investment grade borrowers. Credit spreads on these bonds also look attractive, with one year maturities offering higher spreads to five year ones (see Fig. 3).
Whatever happens to inflation, there is likely to be turbulence in both macro-economic data and financial markets over the coming months. Short-term bonds offer investors the possibility to insulate themselves against that volatility without giving up much yield.
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