What has happened to my inflation hedge?

Central banks are catching up rapidly, with base rates now expected to hit 2.8 per cent in the UK by the end of the year, and 10-year rates having risen to 2.4 per cent from 1 per cent at the start of the year.

This has been a great help to defined benefit schemes in reducing liability values that have ballooned in recent years. However, the impact is being felt very unevenly.

Some schemes’ funding positions have been helped by low exposure to equities and by assets delivering (uncapped) inflation-sensitive returns, against liabilities with capped pension increases.

Those with uncapped pension increases and significant equity holdings, which have fallen around 20 per cent year to date, have experienced a double blow of higher future liabilities and lower asset values

Schemes with significant inflation hedging may find themselves with too much inflation exposure, as sensitivity to inflation pricing is lower when pension increase caps in future years are more likely to be hit.

Those with uncapped pension increases and significant equity holdings, which have fallen around 20 per cent, year to date, have experienced the double blow of higher future liabilities and lower asset values. 

Who is buying linkers?

What is more unexpected is the collapse in index-linked gilts (linkers).

A fall in bond prices is expected when interest rates rise. Usually linker prices are more stable than gilts of a similar duration, as the former are lifted by higher inflation expectations when interest rates rise.

But this year gilt real yields have shot up – as shown in the chart below – with some forward-starting real yields now close to zero. This has been felt most sharply by the longest dated bonds, with Linker 2073 falling in value some 60 per cent since being issued seven months ago.

The drop in demand can also be seen in the most recent major issuance of linkers on June 21, which raised significantly less than expected and led to some choppy prices post-syndication.

Why have linkers continued to sell off despite heightened inflation concerns?

At least part of the answer is to be found by considering the pain that rising leverage has inflicted on liability-driven investment portfolios. 

Many LDI strategies target high inflation protection by funding additional inflation exposure using leverage. When bond prices fall, leverage rises and cash must be injected to restore the balance.

But recent rises have been so sharp that in some cases it is impractical to raise sufficient cash. At worst, this could lead to inflation-linked assets being sold.

More commonly, rising leverage has constrained schemes in being unable to step in to buy linkers to complete their inflation hedge, even at current lower prices. This lack of buying has undoubtedly contributed to the drop in linker prices.

Opportunities available for schemes

Held to maturity, a bond will deliver the cash flows promised. But recent markets have served as a reminder that rather than eliminating risk, hedging is a matter of transforming it into risk that can be better managed.

This serves to underline the value of building up a portfolio that can deliver predictable income that rises with inflation, rather than retaining volatile growth assets alongside (also volatile) hedging instruments.

Inflation-linked gilts undoubtedly have a key role to play here, and current yields certainly offer a substantially lower entry point than much of the past decade. Though even a yield of inflation minus 1 per cent is not sufficient for most schemes to reach long-term funding objectives.

So other assets will continue to be required to complement linkers. While none offer the same hold-to-maturity confidence, inflation-linked income and higher yields can be found through a combination of contractual income and simple exposure to wider ‘real assets’ in the right location, where future demand will be linked to future earnings. 

So while consumer prices are rising at a record rate, attractive opportunities to secure inflation-sensitive income-generating assets are very much available. 

This presents an opportunity for DB schemes to move towards building a resilient physical portfolio of bonds, linkers and real assets. Growth-plus-LDI ‘barbell’ approaches may have had their day.

Derek Steeden is a portfolio manager at Invesco Solutions