Don’t downsize your goals

Two bond market ideas to help
guard against rising inflation

allianzgi.com

November 2021

After many years of falling inflation, the second half of 2021 could beremembered as the time when prices started to rise again. How should bondmarket investors respond? Here are two more ideas.

– Two possible options are inflation-linked bonds and floating rate notes

2021 could be remembered as the year that
inflation returned. For decades inflation has
stayed low globally, but in the last months of2021, markets have experienced hotter-thanexpected inflation and inflation surprises
globally are at their highest level in over
20 years (see Exhibit 1).
Is inflation structural or temporary?
The coronavirus pandemic with all its
consequences – like the shutdown of
manufacturing production in early 2020 –brought inflation to such low levels thateven comparison with the first months of2021 shows significant variations. This is
the “base effect”, which tends to decreaseover the following months as the terms ofcomparison become more homogeneous.
The essential question for financial markets
is whether temporary factors or structuralforces have been more significant in sparking

Value. Shared.

Exhibit 1: following decades of low inflation,
surprises on the upside are increasing globally
Citi inflation surprise indicator – Global
50
4030
20
100-10-20-30
92001
20
03
2005
2007
2009
20
1120
13
20
15
20
1720
192021

Maxia Massimiliano
Product Specialist,
Fixed Income– As inflation erodes bonds’ real returns, a long-term investment strategy should seek safeguards

199Matthew Chaldecott,
CFA
Product Specialist,
Fixed Income

Key takeaways– Higher-than-expected inflation has surprised markets in the second half of 2021, and it
could be more prolonged than many expect

Source: Bloomberg.

Two bond market ideas to help guard against rising inflationinflation’s return. Temporary factors are certainly at play.
They include the rising price of key raw materials, primarilyoil; the strong recovery of economic growth that leads toeffects known as output gaps – where the actual outputof the economy may exceed its potential output; andsupply disruptions.

inflation measure such as the US Consumer Price Index (CPI)or Europe’s Harmonised Index of Consumer Prices (HICP),
rising prices translate directly into higher coupon rates
and principal values. Exhibit 2 illustrates how principals
and coupon values change, from issuance to maturity.

But our economists believe that financial markets may beunderestimating the risk of higher inflation in the medium
term. The consensus view considers the current rise ininflation to be a transitory phenomenon: a view the FederalReserve, European Central Bank and other central banks
firmly support.

To assess the relative attractiveness of ILBs (also known
as “linkers”) against nominal government bonds, we referto the so-called break-even inflation rate, which is thedifference between nominal yields and real yields. In otherwords, it indicates the inflation expectations priced into themarket, or the rate differential at which holding a nominalbond and an ILB of the same issuer and the same maturity
would be equivalent.

In our view, there are good reasons to think that structuralforces – factors that are permanent or sustained – could leadto stubbornly higher inflation. Changes in the labour market,
especially as globalisation reverses, are pushing up the pricesof goods and services. And, above all, the expansionary
monetary policy of the US Federal Reserve and the European
Central Bank, with their adoption of flexible inflation targets,
implies they may be “behind the curve” – and interest rates
could fail to keep pace with inflation.
That said, it is difficult to predict with certainty whether theincrease in inflation will be structural or more temporary, as
the long-term consequences of the pandemic are still notclear. While we clearly do not expect inflation rates to returnto the levels seen in the 1970s, we believe that medium-term
inflation risks are higher than currently anticipated by themarket. We expect inflation premiums to rise slightly andinflation volatility to increase.
Two bond market options for inflationary times
Should higher inflation prove to be structural, there are twooptions worth considering when investing in the bond markets.
1. Inflation-linked bonds
Inflation-linked bonds (ILBs) are designed to protect
investors from inflation as the instruments benefit fromrising inflation expectations. Because their principal andinterest payments are contractually linked to a recognised

When to buy ILBs?

Therefore, if we expected inflation to be higher over thelife of the bond than the break-even rate, we would earn ahigher return holding ILBs, while at the same time having
lower inflation risk. The opposite would be true if weexpected inflation to be lower than the break-even rate.
This means that the best market environment for investingin ILBs is when inflation is rising and markets are pricing
higher inflation in the future, as they are today. This explicit
link to changes in inflation makes ILBs an effective way toincorporate real returns into a portfolio.
A prolonged period of declining prices, or deflation, would
be a less suitable market context for investing in ILBs
because the principle and coupon payments would bebased on the deflationary scenario. However, to mitigate
this risk, more and more ILBs are issued with a deflation
floor. This guarantees that the bond’s principal amountwill not fall below par at maturity, so only the coupons areaffected by the decline in prices.
As with any other bonds, ILBs are affected by interest raterisk, or duration. Interest rate risk could prove topical if real
yields move higher following a shift by central banks to amore restrictive monetary policy, as ILBs usually have long
durations. To mitigate this, portfolio managers can deploy
swaps to isolate and manage the pure inflation risk.

Exhibit 2: nominal value and coupon payments during the life cycle of an inflation-linked bondAt issuanceDuring the lifeCPINominalvalue
Investor pays theoriginal normal valueAt maturity

CPINominal/face value
is adjusted to monthly
CPI changes

Investor receives the higher of:
1. the adjusted or
2. the original face value,
if adjusted value is <100%
Fixed percentage
of a variable(usually increasing)nominal/face value

CouponInvestor will receive realinterest via adjustmentof nominal/face value toupcoming CPI changes
Source: Bloomberg.
2Coupon payments vary,as real interest is linked
to the inﬂation-adjusted
nominal/face value

Coupon payments are
generally linked to theadjusted nominal value

Two bond market ideas to help guard against rising inflation

2. Floating rate notes
Another area of the bond market that can outperform ininflationary environments is floating rate notes (FRNs),
which have their coupons linked to a specified base rate.
Floating rate coupons normally adjust around every threemonths: as the cashflows reset in line with interest rates,
the bond price tends to remain stable around par.
Plain vanilla (fixed) bonds– Fixed coupon until maturity– Sensitivity to rising interest rates– Rate risk defined through duration+1%Duration: 6 years

PriceRates-6%

Floating rate notes (FRNs)– Variable coupons, resetting periodically– Coupons linked to interest rates– Protection against rising rates

Rates:

FRN
coupon:

FRN
price:+1%+1%

StableAn everyday example could be a mortgage with monthly
payments that adjust in line with a central bank’s official rate.
On the other side of the equation, banks and corporations
issue bonds with coupons typically tied to a short-term
market interest rate such as LIBOR (London Interbank
Offered Rate), or the newer interbank indices including
SOFR (Secured Overnight Financing Rate) in the US andSONIA (Sterling Overnight Indexed Average) in the UK.
One potential benefit of linking floating rate bonds tomarket-determined rates is that they tend to be responsive
to inflation risks. By contrast, central bank policy often lags
through inertia or a deliberate desire to support growthand employment. Exhibit 3 shows that the market rate
often (though not always) moves first and further than theofficial central bank rate in response to changes in inflation.
Investors, therefore, benefit from price stability in floating
rate bonds, while gaining additional income if inflationand short-term market rates do rise.
The floating rate coupon’s premium over and above thebase rate is known as the discount margin; it reflects theriskiness of the issuer and the bond itself. This margin
ranges from a handful of basis points for a highly rated
issue backed by prime collateral, to several percent forlower quality corporate bonds.
FRNs therefore contain credit risk, in contrast to ILBs which
are generally government-issued. Also, to simplify a little,
FRN performance can be driven more by market viewson short-term inflation, while ILBs reflect the longer-term
expectations of break-even rates.
As such, the performance of FRNs is linked to the businesscycle and investor sentiment. Individual issues may besubject to credit downgrades or even defaults in the worstcase scenario. Conversely, when economic growth andcorporate results are strong, discount margins will shrink
and FRNs will perform well.

Exhibit 3: central bank inflation moves typically follow market rates
US libor vs federal funds rate vs US inflation
Euribor vs. ECB deposit rate vs euro area inflation
654
32
10-1

19
919
9Source: Bloomberg.

Source: Bloomberg.

3EURIBOR - 3m
ECB Deposit Rate
Euro Area HICP Index

92001
2003
2005
2007
2009
20
1120
1320
1520
1720
1920
21

USD LIBOR - 3m
Fed funds target rate - mid
US CPI Index

92001
2003
2005
2007
2009
20
1120
1320
1520
1720
1920
21

87
654
32
10-1-2-3

Two bond market ideas to help guard against rising inflation

Thinking about the different economic scenarios
presenting themselves, FRNs tend to perform poorly
in times of deflation and contracting growth – the firstquarter of 2020 being a prime example. Strong growthcoupled with rising inflation and short-term market
rates is the best environment for FRNs, as was the case in
2004-6 or 2017-18. Stagflation – high inflation coinciding
with a slowdown in economic growth – would present amixed bag; rising rates would benefit FRNs as coupons
adjusted upwards, however only higher rated anddefensive issuers would perform well. More cyclical andsub-investment grade companies typically require growth
to sustain their debts.
It should be noted that FRNs may reduce, but notcompletely eliminate, interest rate risk, as there can be alag of a few months before the coupons reset. In the asset/
mortgage-backed sector, the bonds are typically secured
by specific collateral or assets of the issuer (so that holdersof the debt, such as the fund, have a priority claim on thoseassets in the event of the issuer’s default or bankruptcy).
The value of collateral may be insufficient to meet theissuer’s obligations, and the fund’s access to collateral may
be limited by bankruptcy or other insolvency laws. Ourinvestment techniques, analyses, and judgments may not
produce the outcome we intend.

A long-term plan to counter inflation
Inflation is one of the most harmful forces that fixedincome investors face, as it erodes bonds’ real returns.
Consequently, a long-term investment strategy should
consider protection against the risk of inflation.
ILBs do not only offer a natural hedge against a risein inflation, they are also an efficient tool for investors
seeking diversification within a broader fixed income
portfolio, as they tend to be less correlated to otherforms of fixed income. Our expertise at Allianz Global
Investors covers not only ILBs, but also a wide range ofperformance drivers linked to inflation, such as inflation
swaps, break-even trades and active management ofduration and curve positioning.
Likewise, FRNs can benefit portfolios at times of rising
inflation and rising short-term rates, even if central banks
choose to let the economy “run hot”. Active management
is also called for here, however, given the possibility ofcredit risk.
To return to the current macroeconomic environment,
higher inflation is back. And while consensus opinion still
regards the drivers of inflation as transitory, we think it will
be higher than many market-watchers expect. For thisreason, it may well be time for investors to seek safeguards.

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