Preserving the real value of the investment


Interest rates on core government bonds across the European continent are at rock-bottom levels. The past month was characterized by a risk-off sentiment in bond markets, triggered by the Italian government formation and the market reaction to the impact on emerging markets of a rising dollar and specific situations in some EM countries (Turkey, Argentina).

At the same time, we see some pockets of inflation left and right.

How can investors protect themselves and maintain their purchasing power?

This month’s View of the CIO offers some insights by Peter De Coensel, CIO Fixed Income at Degroof Petercam AM: “It remains our base case scenario that core Eurozone bonds yields will rise by the end of the year. This view is based on the expectation for a gradually increasing inflation in the Eurozone and on the diminishing support from central bank purchases. We are therefore maintaining our Underweight position for EUR Government Bonds in a balanced portfolio.”

The question is whether fixed income investors who want to have a defensive investment solution that offers protection against inflation have an alternative. DPAM’s answer is that they sure do.

Inflation linked bonds (ILBs) are a particular sub-segment of the government bond asset class in that they are constructed to preserve the real value of the investment.

Inflation linked bonds are pricing moderate inflation scenarios, in line with current inflation prints. In the US, inflation linked bond foresee inflation of about 2.1% over the next ten years, whereas current inflation is at 2.8%, with core inflation at 2.2%. Inflation linked bonds are certainly not pricing in upside surprises, which we consider to be the most important risk to interest rates.

Similarly, European inflation expectations are priced close to their current inflation levels, although these levels are much lower than in the US. In the same way, Japan is pricing in even lower inflation…

What can ILBs do for investors?

Peter De Coensel: “Inflation linked bonds are a sound way to provide real capital preservations over a longer timeframe. Investors seeking to diversify outside Europe, but not willing to take currency risk, may opt for a currency hedged portfolio of linkers. This provides the benefit of a globally diversified portfolio, without the currency risk. Going global adds diversification through exposure to many different markets with their own interest rate and inflation dynamic, typically with higher yield than in Europe. Note that currency hedging will have an impact on the yield of the portfolio.”


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