What does inflation do to bonds?

​Higher inflation means lower real returns on bonds. UK gilt yields look attractive on paper, but once you strip out inflation expectations, investors are getting less than 1% in real terms. For some, that's reason enough to look beyond the traditional 60/40 portfolio.

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Impact of inflation on UK government bonds

by Henry Cobbe CFA, Head of Research at Elston Consulting

Rising inflation makes real return on bonds less attractive

There is a relationship between government bond yields and inflation expectations.
UK 5-year gilt yields (yield to maturity – an annualised rate of total return) are currently 4.57% and have increased as inflation expectations have increased.

How do we cut through the noise to look at “real” (inflation adjusted) yields?

Our preferred approach is to subtract the UK Break-Even Inflation Rate (BEIR) of matching maturity (5 years), currently 3.80% from the nominal quoted yield.  On this basis, the “real” 5 year (total return adjusting for expected inflation) is 0.77%pa.

How does this compare to the start of the year

At the start of the year, the nominal yield for 5-year gilts was 3.93%, the 5-year BEIR was 3.93%, hence the real yield was +1.02% pa.
Whilst 5-year nominal yields have increased from 3.93% to 4.57%, after adjusting for changing inflation expectations, real yield have decreased from +1.02% to +0.77%.  This means that after adjusting for inflation, UK government bonds are offering less attractive returns now than at the start of the year.

Can Real Yield go negative?

Real yields can go negative.  Indeed, with Quantitative Easing (QE) and the near-Zero Interest Rate Policy (ZIRP) that followed the Global Financial Crisis (GFC), real yields went persistently negative.  Real yields reached the most negative extent as inflation accelerated with the post-Covid restart.
The chart above visualises 5Y nominal yields, 5Y breakeven inflation rates and hence the 5Y real yield at 5 year intervals over time to show before during and after the GFC.

What do negative real yields mean?

Negative real yields mean that, after adjusting for inflation, bonds are expected to lose their real value over time.  The negative real yield is the annualised rate of that decline.  They cease to be preservation of value and a diversifier within a portfolio.

Doesn’t that blow out financial theory?

Yes – negative real yields meant that the perceived diversification value of the traditional 60/40 equity/bond portfolio was eroded.  Not because of the equity allocation, but because of the bond valuation.

What can investment managers and financial advisers use as an alternative to bonds?

When real yields are declining or negative, asset allocators can consider alternatives to Bonds such as:

1. Risk constrained Liquid Real Assets as represented by the Elston Liquid Real Assets Index
2. Absolute Return Funds – also known as All Weather Funds which have the flexibility to invest in a broadly diversified range of assets beyond equities and bonds alone.
3. These strategies can include low-volatility rate-sensitive assets, and the “COGs” Copper, Oil and Gold.

What's inside an All Weather Fund?

An All-Weather Fund means it has the flexibility to move between different asset classes - equities and equity-like assets when the growth outlook is attractive, bond when there is prospect of falling inflation and falling interest rates, Floating Rate Notes and rate-sensitive assets when there is the prospect of risiing interest rates, and liquid real assets such as Gold, Commodities, Property securities and Infrastructure securities as near-term and long-term inflation-hedges (assets that are positively correlated with inflation).  Selecting which asset exposures to allocate to, and how much to allocate is the skill of the All-Weather manager.

How to compare All Weather Funds

We look at the IA Targeted Absolute Return sector as the main sector for all-weather funds.  The simplest first filter is 1) what is the rolling 3 year annualised return relative to SONIA (the UK wholesale "risk free" rate for cash/money markets) to show to what extent it has delivered an absolute return, and 2) the amount of risk - relative to Global Equities - it has taken to achieve that.  After that filter comes a deeper dive on holdings, strategy, management team and resource.

How are Break Even Inflation Rates calculated

Break Even Inflation Rates are derived from the annualised difference between Nominal Gilts and Inflation Linked Gilts yields.  They are therefore not a forecast, but a market-derived inflation expectation.  The express the annualised inflation rate that market participants are expecting over that given term.

What is the relationship between oil price, BEIRs, and real yields?

When the oil price rises, BEIRs typically increase, reflecting rising inflationary pressures.  For the same given nominal yield, after deducting a higher BEIR, real yields (the total return on bonds after inflation) decline.
When the oil price falls, BEIRs typically decrease, reflecting falling inflationary pressures.  For the same given nominal yield, after deducting a lower BEIR, real yields (the total return on bonds after inflation) increase.