Make sure your bond holdings are not caught out by inflation

UK government inflation-linked bonds have very high duration, meaning they are at risk from interest rate rises. 

UK inflation has been rising quite steeply since the beginning of the year and now stands above the Bank of England’s medium-term price stability target of 2%.

The consensus view at this juncture is that price pressures may continue to rise for some time yet, but that they are likely to prove temporary. Much of the rise in the annual rate of inflation can be explained by statistical base effects.

In layman terms, inflation was very low in 2020 as the country went into lockdown and this has magnified year-to-year comparisons now that the economy has regained traction. This is why the Bank of England, while keeping a very close eye on developments - most notably the bottlenecks in supply chains, the evolution of energy prices and building wage pressures - doesn’t seem ready to sound the alarm bell just yet.

Whether temporary or not, inflation is not an investor’s best friend. It is a stealth tax that eats away at hard-earned returns. And it can rear its ugly head at any time. In the last decade, there have been multiple periods of above-target inflation.

• Spectre of inflation is trigger for investors to tweak portfolios
• The shares Nick Train is backing to shield against inflation
• 14 investment trusts to inflation-proof your portfolio

This should serve as a reminder that buffeting one’s portfolio against its pernicious effects is one of the key tenets of successful investing. This means not being caught unprepared. Panicky scrambling to protect your portfolio against a risk only when the risk has morphed into a reality is kind of self-defeating.

Inflation protection is probably best thought of as a multi-asset strategy, but one of – if not the – basic building bloc is inflation-linked bonds. These are bonds where the coupon is made up of a fixed and a variable component, with the latter moving up or down in relation to inflation trends, as measured by a recognised consumer price index. In the case of bonds issued by the UK government, that is the Retail Price Index, known by its acronym RPI.   

Passive funds – both exchange-traded funds (ETFs) and traditional index funds – have become a default option for investors seeking a core, that is, permanent, holding in inflation-linked bonds in a portfolio. In addition to offering broad exposure to the market at the click of a button, they come with the very valuable benefit of low ongoing charges, which is crucial to keeping the overall running expenses of investing in check. The iShares £ Index-Lnkd Gilts ETF GBP Dist (LSE:INXG) is a market-leading ETF with an ongoing charge of 0.1%.

Investors in UK government inflation-linked bonds should be aware that this is a bond market structurally biased to very long-dated maturities. This means that indices – and thus the passive funds tracking them- come with very high duration; typically above 20 years.

• Jeff Prestridge: Baillie Gifford’s rare and powerful statement
• A guide on how investors can protect against inflation

The value of bond holdings is greatly exposed to changes in interest rates. Rising rates drive bond prices lower, while falling rates drive bond prices higher. Duration is the measure of sensitivity of bonds to changes in interest rates. It is typically expressed in number of years. The bigger the number, the greater the sensitivity to interest rate moves.

The very high duration of the UK inflation-linked bond market is a nice tailwind to have at times of low or falling interest rates but would cause a drag in performance in the opposite scenario. As this should be a buy-and-hold holding in a portfolio, the ups and downs in valuations in relation to changes in interest rates may balance themselves out over the long term, but this does not mean that one should not proactively act to limit the downside to valuations if the Bank of England were to start increasing interest rates.  

ETF providers have responded to investors’ needs to manage interest rate risk in their portfolios with maturity-segmented fixed-income ETFs. These ETFs offer exposure to delimited segments of the yield curve and can be used tactically to both shorten or lengthen the overall duration of the bond bucket of a portfolio. For example, investors wanting to shorten duration can choose ETFs that cover only the very front-end of the yield curve.  

• Is your S&P 500 ETF at risk of China slowdown?
• ii Super 60 investments: quality options for your portfolio, rigorously selected by our impartial experts

UK investors have a choice of maturity-segmented ETFs tracking indices that include only up to the five-year segment of the UK government bond market and whose average duration is 2.5 years. For example, the Invesco UK Gilt 1-5 Year ETF GBP Inc (LSE:GLT5), iShares UK Gilts 0-5yr ETF GBP Dist (LSE:IGLS) and SPDR® Blmbrg Bcly 1-5 Yr Gilt ETF (LSE:GLTS).

There are also ETFs that only focus on the very short-end of the maturity spectrum, that is up to one year. These typically track indices covering both UK government and corporate bonds and their average duration is around 0.3 to 0.7 years.  Examples include the iShares £ Ultrashort Bond ETF GBP Dist (LSE:ERNS) and the PIMCO Sterling Short Maturity ETF (LSE:QUID).

Jose Garcia Zarate is associate director, passive strategies, manager research, Europe, at Morningstar.