Buck Bond Group
Investing in an inflationary environment

Investing in an inflationary environment

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In our January blog we discussed inflation. We looked at the sharp rise in prices over the past year. We asked if this was just a short-term spike, or the start of something more sustained. In this blog, we look at how to manage the risk of increased inflation prompting substantially higher central bank interest rates.

In a moment, we consider what this might mean for asset prices. First, let’s look at the relationship between inflation and interest rates over the last few decades, and what that has meant for pension funds.

Lower and more stable inflation has coincided with more predictable monetary policy (Chart 1). This has reinforced the expectation of low and stable inflation. Which, in turn, (at least partly) explains the fall in ten-year gilt yields over the period (Chart 2).

These falling yields had a big impact on pension schemes, because of sustained increases in the present value of pensions promises. The bursting of the late-nineties dot-com bubble was a wake-up call for many. The response was to increase the asset allocation to bonds in a strategy that became known as liability driven investment (LDI).

Today’s LDI solutions make extensive use of leverage. Interest rate exposure is typically achieved through derivatives, releasing cash to invest in higher yielding credit strategies and growth assets such as equities.

The main objective of LDI is to reduce short-term funding level volatility.  The argument for doing this is that whilst it reduces risk there is no effect on the expected return. (The reason is that, at the point the hedge is implemented, its “fair market” value is zero. The value to the scheme arises from the increased certainty of outcome). It is for this reason that reference is often made to removing an “unrewarded risk”.

However, because interest rates continued to fall, there were, in fact, three big additional benefits:

  • The “unrewarded risk” has turned out, in fact, to be extremely rewarding when considered in the context of the absolute returns needed to pay members benefits. This has resulted from the decline in interest rates being greater than the market predicted (see Chart 2) particularly after the 2008 financial crisis and subsequent quantitative easing.
  • LDI funds paid out cash to maintain leverage levels which helped with ongoing cash management and portfolio rebalancing.
  • The period since 2008 has seen strong equity market performance, as equity valuations have benefited from the low yield environment. Schemes have been able to benefit from this as a result of the capital freed up by LDI.

Coming back to inflation, all of this happened despite inflation remaining generally low and under control. It has been a goldilocks scenario of profits from bonds AND equities, at the same time as growth in inflation-linked pensions promises remained moderate.

Could all of this be about to change? We have now seen the Bank of England increase base rate in two consecutive months. What if the policy response to the recent inflation spike is to increase base rates substantially beyond current levels? Alongside an end to quantitative easing, this could provoke an increase in long-dated yields and destabilise equities. In that scenario, cash would be sucked back into leveraged solutions. The unexpectedly “rewarding risk” becomes loss making and volatility in growth assets becomes a major problem.

Whilst the resultant losses on interest rate hedges should be offset by a reduction in liability values, it nevertheless means that one real investment opportunity to close the funding gap will be missed. In an environment whereby asset returns may struggle, we believe that trustees still some way from self-sufficiency should carefully consider the merits of underweighting interest rate hedging relative to target. This would be a potentially significant change in strategy, and require careful bespoke consideration, taking account of a scheme’s particular circumstances.

Of course, such a change may, in isolation, increase the Value at Risk. However, this could be offset by reducing the overall allocation to growth assets. This can be done in a way that shouldn’t change the contribution schedule or journey plan time frame.

This would be achieved by re-thinking how portfolios are structured and allowed to evolve over time. We call this Cashflow Centred Investment, or CCI. CCI combines a Cashflow Driven Investment (CDI) portfolio whereby bonds cover the early years benefit payments with growth assets held against longer term ones. In doing this, the growth assets are expected to be held for longer than under more traditional structures with the result that you need to hold less of them today.

Within this framework, there are assets we expect should correlate reasonably well with inflation over the longer term, for example, floating rate debt and property income funds. Further, by biasing portfolios to themes that are likely to drive inflation, such as the switch to net zero and an ageing population, trustees can help mitigate the risks.

  1. Data source: Bank of England.
  2. Data source: Office for National Statistics. Figures are annual RPI over the previous 12 months.
  3. Accumulated 1-year gilt rate at start of each year for 10 years (annualised)

Both data sources contain public sector information licenced under the Open Government Licence v 3.0

Important notice: This article is for Professional investors only and was written as at 18 February 2022. The article is generic in nature and should not be regarded as providing specific advice or a recommendation of suitability. No action should be taken without seeking appropriate advice, taking account of how the market environment has changed since the date of this article. There can be no guarantee that the opinions expressed in this document will prove correct.