European investors look to add inflation protection to portfolios

European pension fund executives are making portfolio tweaks in anticipation that inflation will continue to increase when governments fully lift COVID-19-related restrictions.

Contributing to the inflationary pressure in investors' minds is the backdrop of the European Union and U.S. government's fiscal responses to offset the economic pain of the pandemic, as well as loose monetary policies of the European Central Bank and the Federal Reserve.

Some asset owners in Europe are concerned these factors could combine to create lasting inflation.

"The risk is real that it will be more than just a spike. … I fear that it will be more than that … (and) we might find ourselves in the regime where for several quarters and a few years we will have well in excess of 2% (inflation) per annum" in the U.S., said Olivier Rousseau, executive director of the €26.3 billion ($31.9 billion) Fonds de Reserve pour les Retraites, Paris, in a telephone interview.

In an effort to prevent erosion of their asset bases, some investors are adding inflation-linked bonds. European-domiciled investors steered $253.3 billion into global inflation-indexed fixed-income strategies in the first quarter, compared with outflows of $56.9 billion in the last quarter of 2020, according to data provided by eVestment LLC. European inflation-indexed fixed-income strategies saw inflows of $97 billion from European investors in the same quarter compared with inflows of $10.3 billion in the previous quarter.

But not all investors see adding inflation-linked bonds as the most efficient way to shield against longer-term inflation risk because these bonds are trading at negative real yields. Some investors also are reducing their exposure to government and investment-grade bonds, due to worries that out-of-control inflation may lead central banks to increase interest rates, which in turn could cause yields to increase and bond prices to fall.

In the U.S., the median year-ahead inflation expectation increased to 3.4% in April from 3.2% in March, according to data published by the Federal Reserve May 10. The three-year projection remains at 3.1% month-on-month. According to the European Central Bank, the inflation expectation in the eurozone increased to 1.6% in the second quarter of the year from 0.9% in the first quarter. The same survey showed that over the long term, inflation is expected to reach 1.7% by 2025. Both central banks have an inflation target of 2%.

On the back of increasing inflation expectations, executives at FRR reduced the fund's allocation to fixed-income, consisting of government bonds and investment-grade bonds, to 45% from just under 50%. The fund's executives are focused on increasing high-yield bond exposure instead, to a target of 10% from a 5% allocation. Mr. Rousseau said that while inflation-linked bonds provide protection from inflation, they also mean investors are getting a negative real yield. "High-yield bonds are ugly but not as ugly as the rest" of developed market fixed-income, he added.

Alex Koriath, head of European pension practice and regional head of Germany at Cambridge Associates Ltd. in London, agreed with Mr. Rousseau. "If you buy index-linked gilts, you get protection against inflation, but a meaningful inflation (expectation) is already priced in, and you are locking in a negative real yield. If you buy a 20-year index-linked gilt you are locking in -2%, which is significant," he said.

Other investors are also reducing nominal bonds exposures as well as increasing inflation-linked bonds exposures.

"Inflation risk has been rising especially if you look at the short end of the curve … (the) market is agreeing that we will have an inflation spike," Christian Kjaer, head of liquid markets at ATP, Hilleroed, Denmark, said in a telephone interview.

Mr. Kjaer said the 906.6 billion Danish kroner ($148 billion) pension fund is currently overweight inflation-linked assets to hedge inflation risk by shorting nominal bonds against inflation-linked bonds via swaps and through commodities. The fund's exposure was recently increased to about 16.5% up from 15%, Mr. Kjaer said.

"We are worried about inflation increasing rapidly," he said, adding that rising inflation can negatively impact both bond and equity returns and reduce the benefits of diversification.

At the same time, executives are underweighting ATP's 35% target interest rate risk exposure. ATP doesn't split out allocations by asset class, but allocates its portfolio by risk, covering equity, interest rate, inflation and other risks.

The 42.5 billion Swiss francs ($47.1 billion) Swiss federal pension fund PUBLICA, Bern, is also adding inflation-linked bonds to its portfolio. Executives have been overweighting a 6% strategic allocation to U.S. and eurozone inflation-linked bonds in recent months. Stefan Beiner, CIO and deputy CEO of the pension fund said that the probability of higher inflation has increased because of expansive monetary policy from central banks and fiscal policy with spending packages of sizes that have not been seen since World War II. The pension fund, which swapped nominal bonds for inflation-linked bonds, can increase its strategic allocation to inflation-linked bonds to a maximum of 7.2%. Mr. Beiner did not disclose the fund's current allocation.

For some investors, the duration of the anticipated increase in inflation isn't clear. Gregoire Haenni, CIO of the 21 billion Swiss francs Caisse de Prevoyance de l'Etat de Geneve, the pension fund of the State of Geneva, said that the pace of inflation decline following a spike in the next months is highly uncertain.

Mr. Haenni added that the fund's 3% U.S. Treasuries allocation could be impacted by higher inflation, which is digestible. "Any (market) correction could be limited by two factors," he said. The first is that the Fed may implement yield control tactics because "the economy can't afford higher interest rates." The second factor is that, at some point, the "Treasury yield will become more attractive than dividends and investors will reconsider U.S. Treasuries," he said.