Inflation is coming, and with commodity prices and property valuations in decline, some investors are allocating to inflation-linked bonds, which are built to outperform once economic growth is hit and real yields fall. But ‘linkers’ carry illiquidity and volatility risks that can undermine their appeal. How should superannuation funds approach these assets? SIMON MUMME reports.

Robert Mead at PIMCO says the best protection against inflation is short-to-medium term government debt. The assets provide more attractive returns, and are less volatile, than what some say is a more intuitive defence commonly used by defined benefit and insurance funds: inflation-linked bonds (ILBs). Mead, head of portfolio management for PIMCO in Australia, points to the outperformance of medium-term government debt over ‘linkers’ in recent years, notably its return in 2008 of 11.2 per cent against the 8.5 per cent from ILBs.

In the year to date, medium-term government debt has garnered 0.3 per cent against the -2.7 per cent return from ILBs, and with less volatility. “Medium-term fixed income instruments remain very attractive for absolute and real returns,” he says. Past years have seen ILBs outperform nominal bonds, but the distress following the demise of Lehman Brothers in 2008 froze the market for the instruments, resulting in negative returns and highlighting the ease with which this small market can become illiquid.

The episode also exposed the volatility of ILBs, which, due to their longer lifespans, generally have rollercoaster return profiles compared to nominal bonds. “ILBs are more volatile because they have a longer duration as interest rates move around irrespective of inflation,” Mead says. Taking these risks into account, PIMCO opted to hedge its portfolios against inflation by investing in the intermediate part of the yield curve for nominal bonds. Expected returns are slightly lower, but the debt carries less volatility and illiquidity risk, and is offered at a lower price.

The clear aim of the Reserve Bank of Australia (RBA) to keep consumer price inflation between 2 to 3 per cent will also keep returns from ILBs and medium-term nominal debt in the same range. “Given the very clear mandate from the RBA, and the fact that the Australian Government will not assume the amount of debt that the US and UK have taken on, there is no real incentive for inflation in Australia to pick up, and for the government to inflate debt away.” Although ILBs offer guaranteed protection against inflation, the determinant as to whether institutional investors should buy them in the current environment is their face valuation. “For all portfolios, we consider them as viable investments.

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