With inflation on the rise in many countries, there is currently talk in the news about further rate hikes by the US Federal Reserve, the Bank of England & the first-rate hike in Europe by the European Central Bank. Given the wide range of views of market commentators, how long this era of rising interest rates will exactly last for is hard to say.
The ETF market offers several tools to mitigate interest rate and inflation risk. If more and more central banks continue to hike rates, which is usually a bad time to invest in bonds following the maxim as rates go up bond prices go down, which Fixed Income ETFs could offer the investor an opportunity to take a view on inflation?
A deep dive into the full range of bonds available to investors is quite an extensive topic to cover, however keeping things simple, when one thinks of traditional bonds, these will often pay a fixed coupon and redeem at par. Depending on the credit rating of the bond issuer, these bonds will carry some default risk impacting the fair value of the bond.
In contrast, inflation-linked bond holders will receive a coupon that is linked to the level of CPI and are therefore sensitive to the changes in the level of inflation. When estimating the fair value of an inflation-linked bond, a CPI dependent coupon does present the challenge of how to model the future level of inflation, and indeed the path of interest rates. Over a short-term horizon market consensus is more likely to be aligned to the level of inflation than over much longer periods.
When offered in an ETF format, a conventional bond ETF tracks a diversified index comprised of many conventional bonds, and likewise when the ETF offers exposure to inflation-linked bonds. In both cases the value of the ETF will be driven by the supply and demand curve as investors express their views on the future level of interest rates and inflation, which explains why the market price fluctuates over time.
Unlike a single bond, which has a maturity date, a bond ETF will add new bonds to the fund as new issues are placed in the market. The exact details of which bonds are included often follows a complex set of rules, but much like the constituents of the FTSE 100 Index, the index holdings evolve through time. In the case of Inflation-Linked Bond ETFs, the bonds will usually be issued by a government. In the US the best-known example are TIPS, which is short for Treasury Inflation-Protected Securities, and as a government backed security, comes with a high credit rating.
Over the years, the ETF industry has launched several ETFs that track indices comprised of TIPS or alternatively track UK Linkers issued by the UK government. As an investor there is quite a wide range of products, covering different geographies and bond maturities. And as the ETF industry has become more established, the level of choice now extends to inflation-linked bonds issued by Emerging Market economies.
Finally, we come to the category of Fixed Income ETFs that track indices offering exposure to break-even inflation, which, according to the Bank of England’s website (Ref 1), is defined as the average inflation rate that would have to occur over the life of the bonds for the uplifted index-linked bond to generate the same nominal return to maturity as the conventional bond.
In all cases, the value of the ETF is driven by supply and demand, and there is no guarantee that, having chosen one of the various types of Inflation-Linked ETFs, any future returns will be favourable to your initial investment. What there is though, is the option to take a view on inflation in its various guises.
According to Algo-Chain’s online database tool that tracks ETFs listed on the London Stock Exchange, as of the start of May 2022 (Ref 2), there are 38 listed ETFs provided by 6 issuers, that offer exposure to a wide range of inflation-linked indices.
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