Pure relative value tops inflation linked bonds
Pure relative value investing wins out in the inflation linked bonds sector as strategies that avoid macro-economic effects offer better defensive protection during the COVID-19 pandemic.
According to FE Analytics, within the Australian Core Strategies universe, the fixed interest inflation linked bonds sector had an average return of 1.67% over the previous 12 months to 31 May, 2020.
The best-performing fund in the sector was the Ardea Real Outcome fund, which returned 5.94%, followed closely by Mercer’s Australian Inflation Plus fund (4.45%).
Rounding out the top five was Morningstar Global Inflation Linked Securities (2.26%), BlackRock iShares Government Inflation ETF (0.74%) and Vanguard Australian Inflation Linked Bond (0.46%).
Gopi Karunakaren, Ardea portfolio manager, said the firm specialised in pure relative value investing where the level of yield was not relevant.
“We don’t try to predict which way interest rates are going, whether economies are doing well or badly or what the market environment is – none of that is relevant,” Karunakaren said.
“That’s one of the main reasons why the fund has been doing so well, because they’re not being affected by low yields and all of the macro-types of uncertainty.”
Karunakaren said in this type of approach it was completely independent of macro effects.
“Our fundamental approach to investing is that we can’t predict which way economies are going to go so we don’t even try to,” Karunakaren said.
“We don’t know if inflation is going to be high or low in the future and I could sit here and make a compelling argument why inflation should stay low forever and then I could turn around an make an equally compelling argument for why inflation will rise.
“What is clear to us is many markets, including inflation linked bond markets, are currently pricing in a scenario in which inflation remains low very far into the future.”
The strategy of the fund was to prioritise capital preservation by only investing in ‘high quality’ government bonds, related derivatives and cash-like investments.
“If you look at the pricing of inflation linked bonds right now – the prices in that market are basically are implying that inflation is going to remain very low, not just for the next year, but for the next 10, 20, 30 years,” Karunakaren said.
“It’s very easy to see why inflation could remain low in the near term because of economic weakness, that’s fairly obvious.
“But it’s much less obvious to us that inflation can remain that low for in 10-30 years in the future, at a time when you’ve got huge monetary and fiscal stimulus being announced everywhere.”
The fund was split between state (62%) and national (38%) government bonds, with 65% being in Australasia.
“If you were to get some kind of inflation surprise coming out over the next 2-5 years, markets aren’t prepared for that at all so you could see pretty violent price reaction across fixed income markets and inflation linked bond markets,” Karunakaren said.
“We view that as a very kind of asymmetric-type of position where one scenario is being heavily priced-in and others being discounted as not having any probability of happening and that creates some interest opportunities.”
Best-performing fixed income inflation linked bond funds versus ACS Fixed Interest Inflation Linked Bonds sector over the year to 31 May 2020
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