Why corporate bonds are an effective hedge against inflation

Quality bonds are less prone to significant price declines, making them an ideal choice for inflationary times. Getty Images

Investors prioritise safe and steady returns and capital preservation, especially during periods of uncertainty.

One potent investment strategy for achieving this is investing in bonds, which are considered safer than equities and effectively hedge against a volatile economic environment.

However, investing in bonds during high inflationary periods requires careful planning and strategic selection.

As long as inflation stays well above 2 per cent, US Treasury yields are expected to remain elevated.

If the economy slows down, demand for US Treasuries might rise, but the Fed's hesitation to introduce substantial rate cuts will likely offset this increased interest.

On the other hand, Europe's inflation rate has dropped below that of the US, potentially allowing the European Central Bank to adopt less restrictive monetary policies despite inflation still being above its target, setting the stage for the next quarter.

Despite the widely-expected and well-publicised interest rate cut in June, ECB policymakers seem reluctant to deviate further from the Federal Reserve’s monetary policy stance.

They continue to base decisions on data rather than committing to a specific interest rate trajectory for the rest of the year.

Consequently, short-term interest rates will likely remain stable, with yield curves possibly steepening slightly as long-term rates rise slowly.

At the same time, the European economy rebounds and the pandemic emergency purchase programme disinvestments commence in July.

In the third quarter, investors face a complex bond market in which volatility will remain high due to the divergence in European and US rates.

Hence, investors are advised to take a cautious stance.

Corporate bonds are likely to remain supported

The current state of the bond markets also showcases the broader economic environment.

A lull in the primary markets and persistent inflation lead investors to seek higher returns.

The credit spread – the yield difference between a corporate bond and a comparable sovereign bond – continues to be tight, indicating that risk appetite remains elevated.

The tighter the credit spreads, the further investors will be pushed down the risk ladder and seek better returns.

During economic uncertainty, investing in bonds issued by highly rated entities provides a stable income stream and reduced default risk.

Further, quality bonds are less prone to significant price declines, making them an ideal choice for such times.

Yet elevated inflation raises concerns about capital erosion. High-yield corporate bonds have been an effective hedge against inflation so far.

With the uncertainty around central banks’ success in curbing inflation a significant concern, high-yield corporate bonds could continue to be a valuable tool to create a buffer against inflation.

However, cherry-picking with thorough analysis is critical.

Duration extension might need to wait

Prices of longer-duration bonds are more susceptible to interest rate changes and economic activity, so limiting bond maturities to five years is preferable.

In a constantly changing interest rate environment, investors can better navigate price volatility risk by holding bonds of a shorter duration. These bonds are less sensitive to rate changes and offer more predictable returns.

Until inflation stabilises, bond investing will be about blending caution and careful selection.

Investors can navigate the current volatility and uncertainty by focusing on corporate bonds and shorter duration.

As the market conditions evolve, this strategy allows investors to seize opportunities while protecting their portfolios from significant losses.

Even in these challenging times, investors can achieve their financial goals by being more adaptable and staying informed about ongoing developments.

Althea Spinozzi is head of fixed income strategy at Saxo Bank