Phil Redding of Aviva Investors explains how inflation in emerging markets can benefit your portfolio.
The prospect of inflation is drummed into us by headline after headline. Rising prices stretch our incomes and erode savings. For pension investors concerned about liabilities measured in decades, periods of high inflation can be a primary cause of concern.
But not all inflation is bad. And comparatively high inflation rates in some of the world’s fastest growing economies have the potential to provide attractive opportunities for investors.
Inflation-linked bonds, issued by governments in emerging markets (EM), give savers a return tied to changing prices in nations such as Brazil, Israel and Thailand.
Investing in such bonds allows funds to seek to hedge some of their own inflation exposures, and secure decent returns. With bond yields in developed markets near historic lows, returns from EM inflation-linked bonds look attractive. Average EM real yields are around 4.5%1.
In the longer term, there is the chance to gain as the economic balance of power switches from the indebted developed world to cash-rich emerging markets.
In our view this is likely to see the real rates of return on EM bonds converge with developed markets and yields decline, boosting the value of holdings for existing investors.
Research from the Aviva Investors in-house strategic asset allocation team forecasts long-term (over ten years) annual returns for a UK investor of 6.1% for local currency EM bonds and 8.1% for local currency inflation-linked bonds.
Inflation expectations in these markets remains high. Energy and food costs continue to rise and most governments are still prioritising growth over capping inflation.
For a pension investor, exposure to EM inflation-linked bonds also aids portfolio diversification, with a low correlation to the performance of other assets. The market for EM inflation-linked bonds has grown from less than $20bn at the end of 2003, to more than $460bn2.
Thailand issued its first bonds this summer, and India is gearing up to enter the market next year. Meanwhile, the credit quality of this debt has improved. Almost 90% of bonds in the benchmark Barclays Capital index are now investment grade, up from 48% six years ago.
This broadening and deepening of supply is being matched by a growing awareness from pension investors. Pension funds in developed economies currently allocate less than 1% of assets to EM debt. But some forward-thinking funds are pushing this out to nearer 3%-4%.
With many emerging market economies holding strong currency reserves and running budget surpluses, the risks of EM bonds is as much political as financial.
A sudden change of government can leave a nation unwilling to pay its dues, even though it is able to. So successful EM bond managers keep a weather eye on political risk and will be able to demonstrate that they have avoided any defaults over the past decade.
Investors may also wish to consider managers with a wide experience in EM bond markets and the scale to enable them to participate fully in new issues.
In our view, trustees may benefit from thinking about how best they can position their portfolios to capitalise on the opportunities in EM bonds and to make inflation their friend.
Unless stated otherwise, any opinions expressed above are those of Aviva Investors Global Services Limited (Aviva Investors). They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature