- Inflation-linked bonds are considered inflation-hedges
- However, these have lost almost as much as plain-vanilla bonds in 2022
- The sensitivity to interest rates matters more than that to inflation
Inflation is the biggest issue facing the U.S. and is more important to citizens than crime, health care, or immigration according to a Pew Research Centre survey from May 2022. Given inflation of close to 10% this year, this is unsurprising. Unfortunately, the financial advice retail investors are receiving for dealing with inflation is often poor. For example, a recent Forbes article highlighted five options, where the first one is investing in a high-yield savings account that pays up to 1.5% interest per annum. Inflation was 8.3% in August in the U.S., which implies a negative real return of 6.8%.
The second option recommended by Forbes was investing in inflation-linked bonds, which is also often referenced by professional investors. We previously noted in an article (Inflation-Themed ETFs: As Complicated as Inflation) that these types of fixed-income instruments were not highly correlated with inflation as their principal amounts get adjusted to changes in the consumer price index with a delay. In this research article, we will explore the performance of inflation-linked bonds in year-to-date 2022.
Performance of inflation-linked bonds
Investors can buy single inflation-linked bonds like Treasury Inflation-Protected Securities (TIPS) directly or via ETFs. We focus on three ETFs that provide exposure to inflation-linked bonds from the UK, European, and U.S. governments. These manage between $800 million to $30 billion in assets and charge management fees from 0.09% to 0.19% per annum. Given the high inflation in most countries in 2022, investors might expect inflation-linked bonds to have outperformed and have generated attractive diversification benefits for traditional 60-40 portfolios that fared poorly. The trends in performance were similar, especially for European and U.S. inflation-linked bonds, but none of these ETFs generated positive returns.
Bonds are expected to lose value when inflation is rising as central banks tend to increase interest rates, which has happened in 2022. Inflation-linked bonds are considered diversifiers for such an economic scenario and are expected to perform well, but the UK ETF holding such securities lost 28% of its value in year-to-date 2022, despite inflation being above 10% in the UK, which is a truly abysmal performance. It seems that the performance of inflation-linked bonds was uncorrelated to inflation in all three capital markets.
Long-term performance of U.S. TIPS
Contrasting the performance of inflation-linked (TIPS) and plain-vanilla government bonds in the U.S. highlights a similar performance over the last decade. For the avoidance of doubt, TIPS are also issued by the U.S. government. We observe that TIPS performed significantly worse in 2013, where inflation decreased to 1.46% compared to 2.07% the previous year, but also outperformed in 2021 as inflation started rising given supply chain issues from the COVID-19 crisis. However, the performance in 2022 is surprising as inflation increased further, where investors would likely have expected significant outperformance of TIPS.