How to hedge inflation risks optimally

– Can Nordic institutional investors learn from international investors?

It is here. It is now. Inflation is a widespread global phenomenon, and investors must protect their portfolios accordingly or suffer the consequences. 

“Regardless of whether inflation will be transitory, extended or persistent, if you have not already done so, now is probably a good time to diversify and hedge your portfolio,” says Christian Østerbye Vejen, Chief Portfolio Manager and head of the global inflation team at Danske Bank Asset Management.

A global portfolio of inflation-linked bonds offers positive carry, better diversification and similar liquidity to corresponding swaps.Christian Østerbye Vejen,
Chief Portfolio Manager and head of the global inflation team 
Inflation boom
Last week, Denmark experienced its highest annual inflation rate since 2008, eurozone inflation climbed to a record 4.9 per cent and the United States recorded its highest annual inflation rate since 1982.

Different hedging strategies
Inflation risks are easily hedged via inflation-linked bonds, inflation swaps or ETFs. According to Christian Østerbye Vejen, a global portfolio of inflation-linked bonds offers positive carry, better diversification and similar liquidity to corresponding swaps -- and bonds are also more attractive in pricing terms, offering a pick-up relative to swaps of around 10-20 bps, as measured by relative z-spreads, and 20-40 bps in terms of relative 5 year / 5 year break-evens. 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 nominal duration.

Most of our international investors prefer to hedge inflation risks via a diversified portfolio of global inflation-linked bonds rather than inflation swaps or ETFs.Nicolaj Holm-Christiansen,
Co-Head of Asset Management Sales
Significant inflow from Japanese investors
After warning about not only short-term drivers of inflation but also more long-lasting structural drivers of inflation in a series of webinars at the start of 2021, Danske Bank Asset Management has seen investors use bonds, swaps and ETFs to hedge inflation risks this year.

“However, most of our international investors prefer to hedge inflation risks via a diversified portfolio of global inflation-linked bonds rather than inflation swaps or ETFs. For example, we have seen significant inflows into our global inflation-linked bond strategy from Japanese investors. In fact, we now manage the largest global inflation-linked bond fund in Japan – a country that has not seen notable inflation for 30 years,” says Nicolaj Holm-Christiansen, Co-Head of Asset Management Sales at Danske Bank Asset Management.

Expect more interest from Nordic investors
According to Nicolaj Holm-Christiansen, these investors acknowledge that inflation is a global phenomenon and that to properly hedge the risks you need a diversified approach to protect your portfolio from idiosyncratic events such as the European debt crisis, Brexit, the taper tantrum, etc.

His colleague Stefan Vakker, Co-Head of Asset Management Sales with focus on Nordic clients, expects that many Nordic investors will gradually adopt hedging strategies similar to many international investors.

“Relying on a global diversified bonds approach to hedge inflation risks certainly has its benefits,” he says.

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.

For more information about our products and services