How should investors best seek inflation protection?
Fixed income and credit investors had a rough time in 2022, facing a double whammy of higher interest rates and wider credit spreads. Both of these hurt bond prices, which move in the opposite direction of yields.
The iShares Inflation Hedged Corporate Bond ETF (LQDI) aims to offer investors some inflation protection, by tracking the BlackRock Inflation Hedged Corporate Bond Index. This is made up mainly of investment grade corporate bonds and some inflation swaps.
Conceptually, combining corporate bonds with inflation protection is an appealing idea, but in practice the product design ignores interest rate risk and in a year like 2022, the violence of moves in rates was so great that it overwhelmed the inflation protection.
Inflation in itself is not necessarily the biggest threat to corporate bonds, and in one sense inflation helps any borrower whose revenues increase faster than their debt, which is nominally fixed. Inflation has recently had greatest adverse effects through spurring central banks to increase interest rates.
With interest rate duration of around eight years, LQDI has a high level of interest rate sensitivity, which is greater than seen on high yield bonds that are generally shorter duration. And this rate sensitivity probably explains much of the losses of 14.93% seen in 2022. In approximate terms, duration of 8 means than a bond loses 8% for a 1% rise in rates.
The sister product, LQD, which invests in investment grade corporate bonds without the inflation protection, lost 18% in 2022. Thus, we can infer that the inflation swaps in LQDI have probably reduced losses by about 3%.
Inflation swaps are not the same as inflation linked debt. Investors in a pure play inflation linked ETF without any corporate bond exposure would have done even worse. The iShares Global Inflation Linked Government Bond UCITS ETF (IGIL), tracking the Bloomberg World Government Index Linked Bond Index, lost 22% in 2022. This product has an effective interest rate duration of over 9 years, which is even greater than LQDI, because government bonds tend to have longer maturities than investment grade corporate bonds.
Investors who have homed in on the interest rate impact of inflation, might be better off going for a floating rate products such as those Ultumus has written about before. For instance, the iShares Floating Rate Bond ETF (FLOT) actually posted a positive return of 1.23% in 2022.
With short term US dollar interest rates now higher than medium and longer term rates, other floating rate assets such as cash, money market funds or regularly rolled short dated Treasury bills could be an option. If investors want to avoid corporate credit risk altogether, and have minimal interest rate duration risk, they might look at a Treasury bill ETF such as iShares $ Treasury Bond 0-1yr UCITS ETF (IBTU), which made 1.04% in 2022.
FLOT was very slightly down in the first quarter of 2023, as it lost about 2% in mid March around the time of the banking crisis. The product holds bank issues that sold off after the Credit Suisse AT1 CoCos were bailed in, ie saw a total loss of value, and also had some exposure to Credit Suisse. The performance drawdown was however mainly caused by an increased discount to NAV, which peaked at 1.79% on March 15th and was recently back down to about 0.23% as of April 4.
In contrast, another Treasury Bill ETF, BIL, has hugged its NAV very closely, trading at premiums of between 0.01% and 0.05%.
IBTU is up over 1% year to date as of early April, and might be a “cleaner” way to pick up floating rate interest rate returns, without the complications of exposure to corporate or banking risk
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