Articles - Inflation protection in fixed income

 By Hugo Gravell, Principal and Investment Consultant and Chris Pritchard, Principal and Co-Head of Insurance Investment, Barnett Waddingham

 Myth-busting: correlations between asset classes and short-term inflation

 Over rolling one- and five-year periods since 1986, fixed income assets have outperformed inflation about as frequently as equities and UK property (see Table 1). The critical difference lies in the magnitude of losses when they fail to do so – when equities and property have underperformed inflation, the setbacks are typically far more severe.

 The same can be said for commodities and gold, which are often regarded as strong inflation hedges. Their short-term performance can be highly volatile and unpredictable, offering no guaranteed protection against rising prices. For example, investors who purchased gold before a downturn in the early 1980s would have waited 25 years before recouping their investment, only to find prices had risen by over 160% over the same period.

 In our view, the threat of inflation should not distract investors from the role that fixed income can play in their portfolio.

 Table 1 - Percentage of periods in which asset classes outperformed UK inflation (since 1986 unless otherwise stated)

 Source: Office for National Statistics, FTSE International Limited, MSCI, S&P Dow Jones Indices, Markit iBoxx, LSEG Datastream. CPI data prior to 1989 is based on historical modelled estimates of CPI. Based on monthly rolling periods.
 1Results for UK equity broadly align with Global equity.
 2Property data provided since July 1999, Investment grade corporate bonds since May 1998.

 Table 2 - Average annual underperformance in years when asset class underperforms inflation

 Source: Office for National Statistics, FTSE International Limited, eVestment, S&P Dow Jones Indices, Markit iBoxx, LSEG Datastream. CPI data prior to 1989 is based on historical modelled estimates of CPI. Annual returns on monthly rolling basis.
 
 Managing inflation risk within fixed income
 A well-structured fixed income portfolio can strike a balance between inflation protection and other priorities.

 Risks posed by inflation:

 1. Purchasing power. Inflation reduces the purchasing power of money. Assets with fixed returns, such as cash and fixed interest bonds, will therefore suffer in real terms.

 2. Central bank intervention. Central banks may raise interest rates to combat high inflation, increasing borrowing costs for both companies and consumers. Fixed interest assets are often hit hardest, as investors favour newly issued bonds paying higher interest rates.

 3. Supply and demand. Rising input costs and reduced consumer purchasing power can squeeze company profit margins and increase the risk of default for bond issuers with weaker balance sheets.

 4. Volatility and uncertainty. Higher inflation can lead to unpredictable changes in asset prices, as investors react to new economic data and forecasts.

 Assets with a contractual link to inflation
 This should form the bedrock of a portfolio seeking protection from inflation.

 Inflation-linked bonds
 Redemption and coupon payments on inflation-linked bonds grow with inflation, making them a reliable tool for keeping up with inflation, particularly when held until maturity (see below).

 Based on pricing at the end of September 2025, five-year UK index-linked gilts were expected to provide a yield of RPI + 1% (broadly equivalent to CPI + 2%).

 Inflation swaps
 Investors can also access direct inflation exposure through inflation swaps – financial contracts in which an investor exchanges fixed payments for payments linked to an inflation index. This provides a tool for gaining inflation protection, with flexibility over the contract length and a lower upfront capital requirement than investing in index-linked bonds.

 Avoiding forced selling
 As discussed, inflation is often met with higher interest rates, which puts pressure on bond prices. However, investors will only feel the impact if losses are crystallised.

 Investors will receive the promised yield on bonds if they are held until maturity and do not default, and should therefore aim to hold bonds with maturities aligned to their timeframes.

 Read about the role maturing bonds can play in our ground-breaking vision for the DC retirement market.

 Duration management
 Returns on shorter-dated bonds are less sensitive to rising interest rates. Investors can therefore also reduce the impact of rising rates by maintaining a low duration using:

 Short-dated bonds: typically with a maturity of under five years, meaning prices are less sensitive to interest rate movements.
 Floating rate assets: assets with coupon payments linked to interest rates. As rates rise, coupon payments on these assets increase, protecting the real value of the income stream and providing indirect protection against inflation. Examples include asset-backed securities and bank loans.

 "High quality asset-backed securities are currently an attractive option for short-term investors. They are backed by a diversified pool of underlying loans, providing a source of regular, stable cashflows, with low sensitivity to movements in interest rates."

 
 Figure 1 – Annual nominal return of bonds of varying durations during 2022
 Source: Markit iBoxx, eVestment

 Diversification
 A multi asset credit (MAC) manager can actively select and combine a diverse range of fixed income assets, including those discussed above that provide a degree of inflation protection, allowing them to adjust portfolio positioning during in periods of high inflation. MAC managers also tend to maintain a low duration. Manager selection in this area is critical. Investors should find a manager to fit their risk appetite, timeframes and inflationary outlook.

 Figure 2 – Annual real returns of fixed income assets in high vs low inflationary periods since 1998. “Short dated” refers to bonds maturing within five years.
 Source: Office for National Statistics, Bank of England, Markit iBoxx, eVestment, Intercontinental Exchange (ICE) and Bank of America Merrill Lynch (BofAML), Morningstar, eVestment. Annual returns based on monthly rolling periods.

 Conclusions
 Even in inflationary environments, fixed income should remain the foundation of a short-term investment strategy.

 For investors with short-term inflation-linked expenses or strong views that inflation will stay elevated, assets explicitly linked to inflation, such as index-linked gilts, should form the core of the portfolio.

 Other investors can consider short-term bonds and floating rate assets to generate stable returns while managing the downside risks from persistent inflation, especially when held to maturity.

 Investors able to accept more risk can consider a multi-asset credit allocation, combining the discussed principles with exposure to higher-yielding assets.