Bond yields have ticked down recently as investors conclude that central banks have finished hiking. Whether this is right remains to be seen, but my long-standing view is that central banks are always too quick to cut and too slow to hike and so I’d guess that markets are probably correct.
However, this has little immediate impact on the MoneyWeek asset-allocation strategy that I’ve been reviewing in the last few weeks, since we try not to forecast too much: our goal is to have a portfolio fit for all likely outcomes. With that in mind, the 2%-2.5% real yield on inflation-linked bonds still looks better than conventional bonds.
Government-backed linkers are an unusually generous gift to investors since they promise to pay you back in a money that retains its value, rather than money that is debased by inflation. It is true, of course, that politicians could potentially fiddle the inflation statistics to some extent, but if they are doing that, actual inflation is likely to be so bad that conventional bonds will lose even more value.
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There are fewer choices for inflation-linked bond exchange-traded funds (ETFs) than conventional bond ETFs because this is a smaller market, but what’s available is still as much as we need. Most obviously for the UK investor, we have iShares £ Index-Linked Gilts (LSE: INXG). Given that most of us will have liabilities and costs in sterling and be at risk from UK inflation, in principle, it makes sense to have our investment indexed against that. However, as I discussed last time, the UK linker market is structurally messy and so I prefer US Treasury Inflation-Protected Securities (TIPS).
US TIPS Funds
There are also some euro ETFs, such as iShares € Inflation-Linked Government Bond ETF (LSE: IBCI), which is mostly French and Italian bonds and global ETFs, such as iShares Global Inflation-Linked Government Bond ETF (LSE: SGIL), which is around 50% US bonds. But for our purposes, these add little.
First, US linkers have the highest real yields. Second, US bonds are a safe-haven asset – they tend to rally during crises, which is another attractive reason to hold some.
Several of these ETFs are available as currency-hedged funds, such as iShares $ Tips GBP Hedged (LSE: ITPG). Hedging conventional bonds can make sense – the yield you get from bonds can easily be swamped by currency losses if exchange rates move against you. However, in this situation, I see a good argument to hold US linkers unhedged. If UK inflation turns out to be much worse than US inflation, we would expect sterling to weaken against the dollar over time. ITPS has beaten ITPG over five years for this reason (see chart above).
Put all this together, and we will continue to hold 10% in ITPS.
This article was first published in MoneyWeek's magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.
Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.
Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.
He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.
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