Inflation, the old enemy of fixed income markets, is well and truly back. There are deepening concerns in the UK that the uptick in recent months, on the back of scarcity of goods and labour combined with higher energy prices, is not transitory and could become a more prolonged trend.
The Office for Budget Responsibility (OBR) forecasts the Consumer Prices Index (CPI) will peak at 4.4 per cent in the second quarter of 2022. The core inflation measure already reached 3.1 per cent in September – far above the Bank of England’s (BoE) 2 per cent target.
Concerns about the inflationary impulse being more long-lasting have risen, says Aviva Investors head of insurance & pension solutions Moiz Khan. “Although parts of the supply-demand imbalance should fade as economies reopen, as should the energy price impact, there are fears that some supply-side weaknesses may be more persistent, leading to more serious and lasting price pressures.”
Inflation concern
Sarasin Partners economist Niloofar Rafiei predicts that UK inflation could reach a peak of 5 per cent some time next year. “The OBR figures seem a little out of date because they don’t include another potential increase in prices from the energy regulator, Ofgem. Even though we’ve had more than a five-fold increase in gas prices, it’s been limited [in the retail market] because it’s highly regulated,” she says.
Bonds offer little protection against higher inflation. When investors worry that yields will not keep pace with rising inflation, leaving a negative real interest rate, demand will decrease and therefore so will bond prices.
Barnett Waddingham head of DC investment Sonia Kataora says: “If inflation rises significantly and unexpectedly, history shows bonds perform particularly poorly. This should not be a surprise given they provide a fixed nominal return. Inflation erodes that return and, in particular, long-dated bonds should be avoided if real returns are required.”
Impact on yields
If the BoE’s Monetary Policy Committee votes to raise interest rates to control inflation, as many expect it to do as early as its next meeting on 4 November, there will likely be an uptick in bond yields.
In general, if central banks choose to raise policy rates earlier and by more than had been anticipated, then bond markets will react by pushing yields higher, says Khan.
But Quantum Advisory senior investment consultant Jayna Bhullar says while yields could rise, there are two key factors that could keep a lid on them.
“Firstly, it is a question of how quickly rates are increased relative to the market’s expectations, because a lot of that is already being priced into the market. Secondly, there is still a lot of demand for government bonds from other participants in the market such as insurers and defined benefit (DB) pension schemes, which would put downward pressure on yields.”
Fixed income complexity
In DC pension schemes, the focus needs to be on maintaining the value of the members’ purchasing power, therefore linking returns to inflation with, for example, additional growth of 3 per cent.
Independent Trustee Services (ITS) director Dinesh Visavadia explains that bonds are held to bring diversification benefits and dampen volatility from equities and other asset classes.
“Inflation is more of an issue for older members close to retirement and less so for younger members. If inflation is high in the next five to seven years but then it goes back to normal levels, you might find that your portfolio is still delivering the outcome that you want in 30 years’ time,” he explains.
“It is more of an issue for people who are close to retirement [and it is important] to see if the bond allocations are going to be a deterrent to achieving member outcomes.”
Visavadia warns that bonds could now “cost something in the real return because inflation is going up, so it adds to the complexity of designing DC funds and especially default funds.”
Is it the right time to evaluate the value of nominal bonds given inflation going up and the pressures in the economy, he asks. “At the moment we think of them as diversifying assets and income generating assets, but is it still valid and valuable to think of them in that way?”
Less exposure to long-dated bonds
Historically, DC schemes have held long-dated bonds to hedge annuity prices. But, since the 2015 pension freedoms, many schemes have moved away from holding these assets due to the sharp decline in the proportion of members purchasing annuities.
As Kataora says: “In a world where members are no longer required to purchase an annuity at retirement, this long duration exposure no longer serves such a risk mitigation role and can erode members’ savings at the point of the lifestyle strategy when pot sizes are at their largest.”
Before pension freedoms, DC scheme members would typically retire with a pot comprised of 75 per cent gilts and 25 per cent cash. Mercer senior DC investment consultant Niall Alexander says most schemes are moving away from that towards a greater focus on income drawdown, “which is less gilts and more focus on growing assets in the run-up” to retirement.
“Therefore, I don’t think the impact of inflation on bonds will have a huge impact on DC. Where we see gilts still used quite a lot is in lifestyle strategies or something that’s designed for people who are looking to buy an annuity. In that case, you’d say gilts might fall in value… but you’d expect annuity prices to move in the same way,” he says.
Inflation-busting assets
There are several ways to protect members’ portfolios against an ‘extreme’ inflation event. The most obvious is to allocate to index-linked government bonds as they provide a contractual link with measured inflation – but these generate very low yields due to demand hugely exceeding supply.
There are other inflation-linked assets that can provide protection but also give additional growth in returns, which means schemes do not necessarily need to move into just inflation-linked bonds, says Bhullar.
Real assets are commonly touted as investments that can provide good inflation linkage in addition to their long-term returns and potentially ESG-friendly attributes.
The DC pension fund sector has faced challenges in investing in these asset classes due to their illiquid nature, but a lot of attention has been paid over the last few years to get schemes to invest real assets.
During the Budget, the UK government confirmed it will consult on changes to the charge cap on automatic enrolment schemes to allow for investment in illiquid assets.
Kataora explains there are two main types of real assets. Property and infrastructure for example have a “contractual, hardcoded link to realised inflation within income or capital payments”, while commodities and precious metals “are assets that, while being physical, rely on the long-term pricing of those assets to provide that inflation hedge”.
Asset allocation and TDFs
Kataora believes given that inflation risk is an issue for DC members approaching retirement, a sharp rise in inflation could undo years of financial growth. She says: “There may be greater justification for dynamic asset allocation within defaults later in the lifestyle strategy.”
The important consideration for DC schemes is checking their strategy is aligned with what the member’s preferred retirement option is expected to be, says Bhullar.
Bonds might be the right investment for risk mitigation if members are looking to buy annuities – but less so if they are using the pension freedoms. This is where target date funds (TDFs) could play a role because they are “a good example of natural de-risking, providing diversification, and help to bring in dynamic asset allocation that is often missing in default strategies,” says Bhullar.
She says that pension CIOs and trustees are not being reactive to concerns about inflation and are more focused on the long term.
“I think it’s more about focusing on long-term goals and setting a long-term strategy, which should give you opportunity to grow pension pots to the extent you need to. It can be slightly dangerous taking tactical views because clearly they can either go in your favour or not.”.