Inflation-linked bond ETFs: The asset allocation play of 2023

Are markets overestimating the Fed's ability to control inflation?

Tom Eckett

US stock market

Investors are underestimating the potential impact of a second spike in inflation.

This sentiment has driven investors out of inflation-linked bond ETFs so far this year with the iShares $ TIPS 0-5 UCITS ETF (TIP5) and the Lyxor 2-10Y Inflation Expectations UCITS ETF (INFL) seeing a combined $985m outflows, according to data from ETFLogic, as at 12 April.

The picture is similar in the US with investors pulling a combined $2.5bn from the Schwab U.S. TIPS ETF and the iShares TIPS Bond ETF over the same period.

The sentiment is clear. Investors are positioning for inflation to fall back to pre-pandemic levels, as forecasted by the International Monetary Fund (IMF) earlier this week, a boon for risk assets and government bonds.

This has driven demand for fixed income ETFs across the board, however, inflation protection has not been at the forefront of investors’ playbooks.

The reason is straightforward. In an environment where investors expect inflation to fall, inflation-protection bonds make no sense as an asset allocation play.

Earlier this week, the Bureau of Labor Statistics announced US inflation dropped to 5% year-on-year in March, down from 6% in February and its lowest print since May 2021, while core Consumer Price Index (CPI) jumped to 5.6%.

With core US inflation remaining at stubbornly elevated levels, markets are pricing in a 66.8% chance the Federal Reserve will hike interest rates by 25 basis points (bps) at its next Federal Open Market Committee (FOMC) meeting in May.

“Despite the faster-than-expected drop in inflation, we still expect that the Fed will continue to tighten interest rates at least one or two more times before stopping,” George Lagarias, chief economist at Mazars, said.

However, it is the end-of-year rate expectations that is baffling many industry commentators with markets forecasting a 91.4% probability rates will be lower than current levels. This is directly against chair Jerome Powell who said the central bank will not cut rates this year at the last FOMC meeting.

With equity markets perfectly priced, the divergence between the Fed and the market creates an opportunity for investors less bullish about the outlook to add inflation-linked bonds to portfolios.

This is one of BlackRock’s major asset allocation calls this year. The world’s largest asset manager is forecasting the Fed will be forced to stop hiking rates in the face of further damage to the financial system.

Cracks have already started to appear this year with the collapse of three regional banks in the US including Silicon Valley Bank and UBS’s rescue acquisition of Swiss rival Credit Suisse.

“We think the Fed will eventually stop hiking when the damage becomes more apparent,” BlackRock said. “That means it will not have done enough to create the deep recession needed to achieve its inflation goal, so it will be living with some above-target inflation.”

Not only is this a tactical play for BlackRock but it is also one of the firm’s structural trends over the next five years.

“We see sticky inflation preventing cuts in 2023,” BlackRock continued. “The magnitude of our tactical overweight is now closer to our longstanding overweight from a strategic view of five years and beyond as structural trends like ageing populations, geopolitical tension and the energy transition keep inflation higher.”

ETF selection

ETF investors have a number of options when looking for exposure to US inflation protection. The largest ETF listed in Europe is the $4.9bn iShares $ TIPS UCITS ETF (ITPS) which has an average weighted maturity of 7.78 years.

Given interest rate risk is a key driver of any bond performance – including inflation-linkers – any further rate increases will have a significant impact on the performance of ETFs with long duration.

This is why BlackRock’s TIP5, which has an average weighted maturity of 2.48 years, can offer some protection if rates move higher, a smaller risk than 12 months ago, however.

For purer exposure to inflation expectations, the Lyxor US$ 10Y Inflation Breakeven UCITS ETF (INFU) tracks the Markit iBoxx USD Breakeven 10-year Inflation index which is long 10-year TIPS and short US Treasury bonds.

Finally, the Tabula US Enhanced Inflation UCITS ETF (TINF) – the latest iteration to launch in Europe in October 2020 – tracks the Bloomberg US Enhanced Inflation index which combines exposure to US TIPS and US breakevens.

Selecting which ETF to invest in will depend on an investor’s forecast for interest rates and inflation expectations but given rates are unlikely to rise much further than current levels, locking in some duration could be an attractive play in the current environment.

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