5 key questions and answers about inflation hedging

Christian Østerbye Vejen, head of the global inflation team at Danske Bank Asset Management, shares his views on how to hedge inflation risks optimally in a balanced portfolio.

Inflation is still an all-consuming topic in the financial markets. Last week, new US inflation data for December showed the fastest year-over-year pace in nearly four decades, surging 7% – and inflation is not just an American challenge, it’s a global headache.

We have asked Christian Østerbye Vejen, Chief Portfolio Manager and head of the global inflation team at Danske Bank Asset Management, 5 key questions about how investors can hedge inflation optimally.

By buying or replacing some of your nominal fixed income bonds with inflation-linked bonds you can get exposure to both inflation and fixed income duration in an efficient way.Christian Østerbye Vejen,
Chief Portfolio Manager and head of the global inflation team 
1. Inflation risks can be hedged via inflation-linked bonds and/or inflation swaps. What are the main pros and cons?
“A global portfolio of inflation-linked bonds offers positive carry, better diversification and similar liquidity to corresponding swaps. On top of that, inflation-linked bonds are very simple with no collateral management or complex pricing of derivatives that have been on the portfolio for some time. Inflation swaps, on the other hand, are capital-efficient in the sense that you can hedge without spending large cash amounts, and they come without fixed income duration,” says Christian Østerbye Vejen.

2. Why buy inflation-linked bonds if I only want exposure to inflation and not fixed income duration?

“I often hear investors argue that they don’t want exposure to fixed income duration but only to inflation. However, all balanced portfolios have or need fixed income duration. There is a vast amount of scenarios where either duration or inflation sells off or performs, and that is why it is important to have both risk factors included so you get a more robust portfolio. By buying or replacing some of your nominal fixed income bonds with inflation-linked bonds you can get exposure to both inflation and fixed income duration in an efficient way. It is also worth noting that you don’t buy inflation-linked bonds just because you think inflation will go up in the next 3 months. You buy inflation-linked bonds to cover both inflation and duration risk over a longer period."

Great interest in inflation-linked bonds
“Most of our international investors prefer to hedge inflation risks via a diversified portfolio of global inflation-linked bonds rather than inflation swaps. In 2021, AUM in our inflation-linked bond strategies jumped approximately 50 per cent. For example, we have seen significant inflows into our global inflation-linked bond strategy from Japanese investors.”

Nicolaj Holm-Christiansen, Co-Head of Asset Management Sales at Danske Bank Asset Management.

3. Why buy global inflation-linked bonds instead of just buying inflation exposure in German or US bonds?
“Global inflation-linked bonds offer global diversification benefits. Inflation is a global phenomenon and a global risk. If you only buy inflation protection in isolated countries like Germany or the US, you are exposed to idiosyncratic events like the European debt crises, the taper tantrum and Brexit. All events that you had no idea about just a few quarters before. By diversifying thoroughly you will not end up with all your exposure in the wrong country at the wrong time. In addition, in a balanced portfolio you need fixed income and inflation exposure in the countries where you have the equity exposure. To my knowledge, many investors have been good at diversifying equity risk globally. The inflation and fixed income risk needs to complement that."

4. Are inflation-linked bonds still a relevant alternative to swaps if I expect rising yields?

“At the end of the day, buying inflation-linked bonds is a risk management exercise. Even though you expect rising yields, in the risk management assessment you need to both run through scenarios you believe in and those you don’t, and, as I said, you need exposure to both risk factors in a robust portfolio. For example: Having a more robust portfolio means you typically can have more equity exposure, which tends to do well in a rising rate environment."

5. How are global inflation-linked bonds priced compared to inflation swaps?
“Inflation-linked bonds are more attractive in pricing terms, offering a pick-up relative to inflation swaps of around 10-20 bps, as measured by relative z-spreads, which corresponds to 20-40 bps, depending on the funding, in difference between the 5 year / 5 year break-evens in bond and swap terms.”

DISCLAIMER: This content is based on Danske Bank’s macroeconomic and financial market expectations. Developments deviating from our expectations could potentially affect the return on any investments negatively and result in a loss. This material has been prepared for information purposes only and does not constitute investment advice. Note that historical return and forecasts on future developments are not a reliable indicator of future return, which may be negative. Always consult with professional advisors on legal, tax, financial and other matters that may be relevant to assessing the suitability and appropriateness of an investment.

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