With much investor debate focused, unsurprisingly, on the impact of tariffs by the way of Donald Trump, the more fundamental macro-economic issues like the state of inflation have been placed close to a back burner.
But institutional investors, particularly pension funds, should be keeping eye on inflation and see an inflation hedge as an opportunity, according to Jeremy Rideau, EMEA head of LDI and derivative solutions at State Street Global Advisors.
His view is that given the increasingly gloomy outlook for the global economy, investors appear to feel more confident that inflation will not be an issue in the future, and the breakeven inflation rates – the yield spread between nominal gilts and index-linked gilts – at tenor points across the yield curve have fallen.
In addition, as many pension schemes are already well hedged against inflation, demand for inflation protection has waned.
However, despite weakening demand, the supply of index-linked gilts continues to remain relatively elevated given high fiscal deficits.
“Contrastingly, long-dated nominal bond issuance has declined. This dynamic may lead to a further narrowing in the spread between nominal yields and index-linked gilt yields,” Rideau said.
“With most schemes having a significant amount of their liabilities tied to different forms of Limited Price Indexation (LPI), large moves in breakevens will impact their hedging which is often, if not always, simplified into nominal and fully inflation linked proxy cashflow,” Rideau added.
For LPI liabilities, the sensitivity of the liabilities to inflation goes up as inflation approaches the midpoint of 2.5%.
As a result, Rideau said: “The recent weakening in breakevens could see an increase in demand from pension schemes, particularly those who refreshed their liability cashflows before the recent fall in breakevens.”
Therefore Rideau has a suggestion in regards to pension schemes. “For schemes looking to increase their levels of inflation hedging, the cheapest breakeven levels in five years in a world of stubborn inflation presents an interesting opportunity,” he said.
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