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Bonding with Inflation

Missing the inflation target

In 2021 as the world adjusted to a post-pandemic environment, the global narrative of transitory inflation shifted to persistent with Central Banks motivating “higher-for-longer” rates given the stubborn resilience of inflation globally. In the first half of 2023, US services inflation remains elevated, further reinforcing this narrative. This has resulted in one of the steepest rate hiking cycles in history following a decade of easy monetary policy, and the accumulation of demand after pandemic restrictions.

Inflation protection is back in vogue reigniting the investor debate around the benefits of inflation linked bonds relative to their nominal counterpart.

Over the last two decades, the South African Reserve Bank (SARB) has been clear on their policy to keep SA inflation range-bound (3-6%). However, as shown in the chart below, while the SARB is hawkish with their policy, inflation does temporarily diverge from these limits.

Investing in South African ILBs

South Africa is one of a short list of countries offering investors inflation linked bonds in their local currency. Others include the US, UK, Brazil, Chile, and Mexico.

South Africa first issued ILBs in March 2000 motivated by a commitment to keep inflation under control, and to lower the cost of borrowing by capturing the inflation risk premia priced into nominal or fixed rate bonds. ILBs provided pension funds the ability to better manage their balance sheets during a period of inflationary pressure. Today, ILBs make up about 20% of outstanding debt issuance in the country.

Advantages of investing in ILBs

Potential risks of ILBs

Relative value drivers

Bond investors are rewarded with a stable flow of income on capital invested at the instrument coupon rate and an opportunity to grow capital (by more than inflation) depending on the nature of the instrument and valuations over time. Over a period where realised inflation equals expected inflation (based on breakeven inflation rates[1]), return on inflation-linked bonds (ILBs) should match that of the nominal bonds. In other words, the price of a fixed rate bond will factor in inflation expectations meaning a similar return outcome for the investor in an equivalent bond paying an inflation linked coupon rate.

In reality, as highlighted in the chart above, the SARB is not always able to keep inflation within the target range of 3-6%. There are exogenous factors that cause shocks to inflation prints and reality moves out of kilter from initial expectations. It is when these divergences manifest that investment opportunities between the instrument types swing one way or another.

To simplify:

When two similar bonds with different types of coupon rates – one being fixed and one linked to inflation – are held to maturity the following applies:

If realised inflation (over the period) > expected inflation, ILBs bonds will outperform.

If realised inflation < expected inflation, fixed-rate bonds will outperform.

It’s important to note that various factors such as interest rate changes and inflation changes will impact bond values and yields with varying sensitivities (measured by bond duration) so the above would not necessarily apply if the two instruments were not held to maturity.

The chart below effectively measures realised inflation vs expected inflation (breakeven rate = nominal rate – real rate). For illustrative purposes, the R197 (an SA inflation linked bond) and R2023 (an SA fixed rate or nominal bond) are chosen to depict this relationship, during their overlapping period.

Over the last decade, the period between 2019 and present when average inflation has exceeded expected inflation is the only time when ILBs could have been expected to outperform fixed rate bonds if held to maturity. There were brief periods of similar outperformance during 2012-2014 and 2015 periods, but an investor would require perfect timing to capture this relative performance.

The breakeven rate has an embedded inflation risk premium. This explains why there are seldom occasions when a buy-and-hold ILB strategy outperforms nominal bonds in South Africa. The size of this premium acts as a buffer for prospective inflation, and on average more than compensates investors for taking on the inflation risk when investing in a fixed rate bond.

[1] The breakeven inflation rate is a market-based measure of expected inflation. It is the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity.

The value of ILBs in a fixed income fund

Inflation-linked bonds can be a valuable tool for investors looking to hedge against inflation risk and diversify their portfolio. However, they are not without their own set of risks, including the risk of losses due to extreme inflation scenarios or sovereign defaults.

Protecting the real value of an investment during periods of rising inflation is important however investors should carefully consider the risks of investing in inflation-linked bonds and the experience required to invest in these instruments to enhance the return profile of the portfolio.
At Truffle, we have and continue to invest in sovereign ILBs when we believe these instruments offer the best means of diversification and protection against inflation. Our positions in ILB’s are typically limited in size, given our preference for nominal bonds in SA which on average offer investors excess reward for inflation risk. South Africa is also well-known to have an exemplary MPC, who are committed to their inflation targeting mandate. The MPC effectively communicates their policy stance and expectations meaning we are not materially surprised by inflation publications and expectations are usually close to realised inflation rates.

Inflation rates have begun to stabilise in many regions in 2023, however inflation is high compared to the previous decade. We are committed to our valuation-based investment philosophy while staying close to macro-economic and market shifts that can present tactical investment opportunities – whether investing into South African ILB’s or other nominal bonds and instruments across the full fixed income spectrum.

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