Fixed income. Why bother. It’s a dull asset class that simply involves collecting the fixed coupons and managing relatively stable capital prices. And in an environment of better global growth and the increasing threat of inflation, what’s to like? The value erosion from inflation is bad for bonds, right?

Not so fast…

There is another type of fixed income asset that is linked to inflation – in the UK we call these “linkers”. As the level of inflation rises, the income stream generated by inflation-linked bonds increases – they collect more from the coupons to account for higher inflation.

Sounds good. But what about capital prices – surely these are pretty stable?

Not so much…

Since the start of the year a UK government 50-year linker has been down 10%, up 12% and down 12% again. That is not what I would call a stable capital price! As well as offering inflation protection, there is money to be made (and lost!) from inflation-linked bonds.

I see the benefit of linkers when inflation is rising, but can you make money when inflation falls?

Surprisingly, yes!

If inflation is low and going lower, and let’s say accompanied by a general ‘risk-off’ tone, the long end of fixed income assets can rally (showing an inverse relationship with equities) and within that, bonds linked to inflation can rally too. They are likely to move less than normal bonds, but if they are very long dated (such as that 50-year UK government linker), the duration is so large that the capital upside can be huge.

We can also use derivatives to capture falling inflation – these are called inflation swaps. These instruments are traded “OTC” (over the counter) to make money when inflation falls!

Ok….how does this work?

We enter the swap with a counterparty, agreeing to pay them a floating rate linked to inflation – which we expect to fall. In exchange, they agree to pay us a fixed (constant) rate. On a net basis, if our view about inflation falling is right, we will pay less than we receive over time, and have made a profit from the inflation-linked swap.

To enter the swap contract we also pick the time period we want the swap to last and the country of inflation we want it to be linked to. We can even have positions where we expect inflation to rise in one country and fall in another – a sort of inflation arbitrage trade.

Maybe there’s more to bonds than I thought?

Indeed!

The above demonstrates that some fixed income assets can benefit from rising inflation, are not very stable and not just about clipping a fixed coupon. At Kames as active fixed income managers we understand how to take advantage of the inflation-linked market to the benefit of our clients, a part of the market which is often overlooked by others.

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