Analysis-Iran price shock highlights limits of inflation-linked bonds

By Harry Robertson and Amanda Cooper

LONDON, May 8 (Reuters) – Inflation-linked bonds — despite the promise in their name — have stumbled along with the rest of the bond market as the Iran war drives up prices across the global economy and soaring stocks appear the only game in town.

Since ‌the conflict began at the end of February, BlackRock’s London-listed global inflation-linked government bond ETF has fallen around 2%, according to LSEG data.

That’s in line ‌with the drop in the firm’s global government bond ETF, while the S&P 500 share index has rallied 7% to hit record highs this week.

“TIPS (U.S. inflation-protected bonds) and linkers generally provide relative inflation protection versus ​nominal bonds,” said Jonathan Hill, head of U.S. inflation strategy at Barclays. “If you think that it’s a pure inflation hedge, then you’re going to be disappointed.”

The basic premise of index- or inflation-linked bonds is that, over the longer term and especially if held to maturity, investors’ purchasing power is protected as the payments are linked to inflation indices.

Yet in the shorter term, when markets expect central banks to hike interest rates or not make previously priced-in cuts, all bonds tend to suffer. Their fixed payments become less attractive as investors anticipate ‌higher returns from newly issued debt. Inflation-linked bonds are ⁠no exception.

Big investors such as pension funds who hold them to maturity would receive the inflation protection. But in the shorter term their prices can fall when real yields — market interest rates adjusted for expected inflation — rise.

“If inflation goes up, but real yields go up ⁠as well, then the duration side of the bond sells off the same as all bonds,” said Hill. Duration measures how sensitive a bond is to changes in market interest rates, with longer-dated bonds having more.

“Generally fixed income is unattractive,” said Dorian Carrell, head of multi-asset income at Schroders. “You’re better off looking for inflation-adjusted revenue streams, probably on the equity side” — with materials, ​energy ​and utilities presenting opportunities.

SOME LINKERS BETTER THAN OTHERS

Some investors are still keen on inflation-linked bonds. BlackRock ​data shows $2.6 billion was funnelled into inflation-linked ETFs in March, the ‌highest monthly inflow since Russia’s invasion of Ukraine in 2022, with a further $2.2 billion added in April.

One attraction is the assets’ better longer-term performance versus regular bonds.

Barclays’ Hill found that shorter-dated U.S. inflation-linked bonds, which are less exposed to yield swings that could outweigh the inflation uplift, have delivered considerably stronger returns than the broader Treasury market over the last five years.

They may continue to do so if price pressures stay strong, he said, which is plausible given U.S. tax cuts and heavy AI investment. The structure of the assets means they tend to beat normal bonds when unexpected inflation hits.

“As we’ve seen in the past, short-dated linkers may well work, but long-dated linkers can ‌carry too much duration in an inflation-induced bond market sell-off,” said Lloyd Harris, head of fixed ​income at Premier Miton Investors.

INVESTORS LOOK BEYOND BONDS

However, inflation-linked bonds tend to be longer dated. For ​example the average maturity of Britain’s index-linked gilts was 18 years in 2024, ​versus 13 for normal bonds.

Marion Le Morhedec, global fixed income CIO at Fidelity International, said she has sought protection through inflation swaps ‌or breakevens — trades that allow investors to take a direct view on ​where inflation is headed.

“The question is really ​how long this inflation uncertainty will remain,” she said. “Definitely what we are doing in our portfolios is really to keep those short-dated inflation protections.”

U.S. inflation rose to 3.3% in March as energy prices surged in response to the Iran war, from 2.4% in February. British inflation also climbed to 3.3% in March ​while the euro zone rate rose to 3% in April.

Investors ‌have naturally looked toward soaring markets. PIMCO, the world’s biggest bond investor, noted last week that commodities had “behaved largely as theory would suggest,” seeing ​sharp gains.

BlackRock’s Investment Institute, meanwhile, is “neutral” on inflation-linked bonds but “overweight” U.S. stocks.

It summed up the market mood: “Contained damage to global growth from the Mideast ​conflict and strong earnings expectations — particularly in tech — keep us risk-on.”

(Editing by Kirsten Donovan)