Bond market pricing in inflation surge next year

As with shares, some types of bonds are much more resilient than others in the face of rising prices.

Bond markets are expecting the retail price index (RPI) measure of inflation to hit 7% next year.

Mark Benbow, fund manager of Aegon High Yield Bond and Aegon High Yield Global Bond, points out that the 7% figure is currently being implied by inflation-linked bond swap contracts, which are forward-looking.

Benbow says that RPI-linked loan holders are particularly exposed to much higher borrowing costs.

“You don’t need to look far to see inflation - commodity prices are rising rapidly, as are other input costs such as shipping,” he says. “And with the rising cost of living, it’s only a matter of time before employers realise that they will need to increase wages.

“That may sound like a good thing, but consider that index-linked bonds are implying that RPI will hit 7% in 2022. If that comes to fruition, it will disrupt markets, households and students, who are painfully charged student loan interest on an RPI +3% basis, meaning they will be paying interest of 10%.”

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Last week, it was reported that the official measure of UK inflation (Consumer Prices Index, CPI) in September had slightly dipped from the previous month, falling from 3.2% to 3.1%. But CPI inflation is expected to rise further in the coming months, with the Bank of England forecasting that it will hit 4% by the end of the year.

In addition, the Bank of England’s new chief economist Huw Pill warned CPI could rise above 5% by early next year.

In September, RPI stood at 4.9%. CPI and RPI both measure inflation by tracking the changes in price of a representative basket of goods and services over time. The main difference between the two is that CPI does not include the main costs of household expenditure: mortgage, rent and council tax. However, there are also differences to the way the calculations are made. CPI is considered the more accurate measure of inflation.

RPI is consistently higher than CPI (usually around 1% higher), which leads to actual inflation-busting price increases when RPI is used.

In 2013, RPI ceased to be a ‘national statistic’. It is still, however, used in a wide variety of ways, including as a reference index for some government debt. In addition, train firms annually raise their fares based on RPI, as do mobile phone and broadband providers. In addition, student loan repayments are based on the RPI rate of inflation.

In either form, inflation is currently the number one concern for investors. In the latest monthly Bank of America (BofA) fund manager survey, which polls 380 professionals, just under half (48%) said inflation is the biggest tailwind risk for markets.

Investors are keeping a watchful eye on whether the rises in the cost of living proves to be transient (influenced by short-term supply chain pressures in various industries) or more persistent. But, even if it proves to be a temporary phenomenon, markets are expecting an interest rate rise to occur to bring inflation back down towards the Bank of England’s 2% target.

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Inflation is well recognised as the enemy of fixed-interest investors, as it erodes the value of their income. But, as is the case with shares, some types of bonds are much more resilient than others in the face of rising prices.

One example is index-linked bond funds, which pay a coupon linked to the level of inflation. Capital Gearing (LSE:CGT), a multi-asset investment trust, which is a member of interactive investor’s Super 60 list, has 30% of its assets in index-linked government bonds.

Over the past couple of years, the trust’s manager Peter Spiller has been preparing the portfolio for higher inflation. Spiller expects inflation to elevate in coming years owing to the huge government borrowing that has taken place in response to the Covid-19 pandemic.

Global and strategic bond funds are also well-placed to navigate higher inflation. These funds have the flexibility to invest in different types of bonds, shifting exposure between government bonds, investment-grade corporate bonds and high-yield bonds. In interactive investor’s Super 60 list of rated funds, flexible bond options includeM&G Global Macro Bond, Jupiter Strategic Bond and Marlborough Global Bond.

In response to rising levels of inflation, Benbow is seeking opportunities in bonds that are benefiting from rising prices and avoiding those impacted by disrupted supply chains.

“We like companies that make the commodities that are rising fast in price and are thus beneficiaries of inflation in areas such as coffee, corn, cotton and metals – and we like shipping, which is doing very well,” he says. “We also like household names which aren’t affected by supply chain problems, like David Lloyd and PureGym, which still provide a yield of 5% or more.”