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In August, the annual inflation rate across the eurozone hit 9.1%. The upward trend emerged in the final quarter of 2021, causing bond market yields to rise in anticipation of central bank monetary tightening. By the end of August, the 10-year French OAT yield had surpassed the 2% mark. However, when bond yields rise, previously issued bonds become less valuable. ICE – Bank of America indices show that year-to-date French government bond performance has slipped by about 13%, compared with a fall of 4% for equivalent inflation-linked bonds.
Inflation-linked bonds (‘Linkers’) have coupons and principal values that are indexed to the inflation level observed in the country where the bond was issued. While such a mechanism does not necessarily result in a performance level that perfectly matches inflation, it does enable bondholders to partially or totally offset the effects of the rise in bond yields induced by this inflation.
In actively managed portfolios, the interest-rate risk on inflation-linked bonds can also be hedged out, enabling bondholders to benefit from a rise in inflation expectations while cushioning the negative effect of rising interest rates.
In the example above, an investment made on 1 January 2022 in French inflation-linked bonds hedged against interest-rate risk would have generated a performance of around 9% (-4% + 13%) as of 30 August, illustrating the attractiveness of the approach since the beginning of the year. Although current levels may offer slightly less potential, we believe this type of strategy remains an attractive investment.
The opinion expressed above is dated September 2nd, 2022 and is subject to change.
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