Beware rising interest rates when exposed to inflation-linked bond ETFs

If yields start moving in the wrong direction, investors in longer-duration inflation-linked bond ETFs will be wiped out, even if inflation is moving higher

Inflation has been the key risk keeping investors awake at night this year amid concerns the move towards higher prices is not transitory but the first signs of a dramatic regime change.

As a result, investors have piled into exchange-traded funds (ETFs) offering inflation protection this year. According to data from BlackRock, inflation-linked bond ETFs across the globe saw $18bn inflows in the first five months of the year, outpacing the $17.3bn seen in the whole of 2020.

While on the surface gaining exposure to inflation-protection bond ETFs appears a rationale idea, there has been a wide performance dispersion in this sub-sector.

In particular, the direction of yields has been vital in dictating performance. In a rising yield environment, inflation-protection ETFs with a long duration significantly underperform those with a shorter duration.

Highlighting this, in Q1, when 10-year Treasury yields jumped from below 1% at the start of the year to 1.7% by the end of March, the iShares $ TIPS 0-5 UCITS ETF (TIP5) returned 1.13% versus -1.15% for the iShares $ TIPS UCITS ETF (ITPS). ITPS has a duration of 8.9 years versus 2.6 for TIP5.

It is important to note ITPS delivered negative performance even as the 10-Year Breakeven Inflation Rate – the difference between the nominal yield and the real yield – was rising because of its longer duration.

Andrew Limberis, investment manager at Omba Advisory & Investments, said: “With many investors forecasting higher 10-year nominal rates, they are faced with a difficult choice on how to protect against inflation but not be impacted by rising interest rates.”

Somewhat interestingly, ITPS has seen $743m inflows so far this year, according to data from ETFLogic, as at 19 October, versus just $168m inflows for TIP5. This has proven to be the correct decision with Treasury yields remaining at low levels since March.

However, the depth of the US bond market is a crucial factor in ETF issuers being able to offer inflation-linked exposure to different parts of the yield curve.

In the UK, for example, there is not the same luxury because of the underlying gilt market. As a result, Europe’s only inflation-linked gilt ETF, the $1.4bn iShares £ Index-Linked Gilts UCITS ETF (INXG), has a huge average weighted maturity of 21.9 years. This is potentially a risk for investors in INXG as inflation expectations for the next five years are higher than those for 10 years.

The risk of rising interest rates driving yields higher at the longer end of the curve could wipe any potential returns that could be gained from the inflationary environment.

In fact, this scenario looks increasingly likely after Bank of England Governor Andrew Bailey signalled on 17 October the central bank was planning to increase interest rates amid continued inflation risks.

“Monetary policy cannot solve supply-side problems – but it will have to act and must do so if we see a risk, particularly to medium-term inflation and medium-term inflation expectations,” Bailey said. “And that is why we at the BoE have signalled, and this is another such signal, that we will have to act.”

The spike in inflation is probably transitory…but there are other factors to consider

When analysing inflation-linked bond ETFs, an investor’s view on yields should dictate the duration they want exposure to, however, some markets such as the UK do not have sufficient depth to enable access to the shorter end of the yield curve. This could leave investors exposed if yields start moving in the wrong direction.

This article first appeared in ETF Insider, ETF Stream's new monthly ETF magazine for professional investors in Europe. To access the full issue, click here.

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