Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

Inflation and bonds are not the likeliest of bedfellows. In fact, they’re usually at each other’s throats. Inflation threatens to undermine the value of the fixed income that bond holders earn on their investment. A recent rise in inflation expectations is what’s been driving up US Treasury bond yields - because of the inverse relationship between bond yields and prices, a fall in the latter means a rise in the former.

It may come as a relief, then, to know that not all bonds fear inflation. “Inflation-linked bonds” do what they say on the tin - the income you receive on them is tied to the rate of inflation. The higher the level of inflation, the higher the value of the bond.

Our Select 50 choice of favourite investments features one such bond fund, the ASI Global Inflation-Linked Bond Fund. Tom Stevenson, investment director here at Fidelity, recently caught up with the fund’s manager, Adam Skerry, to discuss how his fund works, his investment approach, and his outlook for global inflation levels.

First, the question we’re all asking - how does an inflation-linked bond fund work? Skerry explains:

“The major difference between indexing bonds and nominal bonds (i.e. standard bonds) is that the coupon (the interest) and redemption payments are inflation linked. What you have is an inflation index which every day incrementally increases over time. So, assuming we get positive inflation, your coupon payment will increase incrementally day by day. By the time you get to the redemption payment, it has swollen by the amount of inflation that you’ve seen over the period.”

Simple, right? Whereas a normal, “nominal” bond pays out a fixed level of interest with a redemption sum which will fall in real terms if inflation rises, an inflation-linked bond sees its coupon and redemption payments rise in line with the level of inflation. That makes inflation-linked bonds a good way for investors to hedge against inflation.

It’s Skerry’s job as the fund’s manager to ensure he invests in bonds which not only protect against inflation, but also provide meaningful levels of interest above it. The fund’s objective is to beat its benchmark index, the Barclays Bloomberg Inflation Linked benchmark, by 0.5%.

To achieve that, the manager is helped by his fund’s global remit, which he says offers him “huge diversification benefits.”

Those are proving particularly important now. He says that, although the recovery from the Coronavirus pandemic is likely to be global in scale, “it’s going to be at very different paces and met with very different responses across the world in different regions.” This means that while inflation is likely to pick up globally, it will do so at different rates and to varying degrees geographically.

That’s where being selective is vital for this manager. He explains that different response levels create “imbalances that can be manipulated.”

His focus is very much on the macro level, looking for these global imbalances and seeing where they offer the best opportunities. This means his investment approach differs from that of a typical equity manager, who’s likely to begin by looking at individual stocks before zooming out to the broader macro picture.

Skerry believes his team is uniquely well positioned to uncover these opportunities. He explains that there are very few fund houses that have a dedicated inflation team like his own. Not only can they dedicate 100% of their time to understanding inflation, they can also draw on the company’s wider resources - across fixed income and equity teams - to debate and share ideas.

So, what is the manager’s outlook for inflation?

Skerry acknowledges that these are interesting times for his fund. He points to the near unprecedented levels of both fiscal and monetary stimulus working in tandem as an obvious driver for inflation over the short term. Inflation should be imminent.

But, as we all know by now, these are unprecedented times. Emergency measures have responded to an emergency situation. Skerry is now looking beyond those measures to the recovery phase. He thinks that this transition is marked by a “sea change away from secular stagnation of the last decade or so towards a more stimulated, inflationary type environment.” He cites Joe Biden’s massive infrastructure spending plans as an example. Huge fiscal projects like these, which look well beyond the pandemic, suggest a meaningful shift in approach that could “lead to some kind of price pressure inflation down the line”.

Skerry, then, is not predicting the surging inflation levels that some have worried about. But he does see a broader shift away from the “great moderation” of the last 30 years towards something more expansive that could push inflation higher. Fortunately for investors, his fund aims to help in either scenario.

Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. The ASI Global Inflation-Linked Bond Fund invests in overseas markets so the value of investments can be affected by changes in currency exchange rates. This fund uses financial derivative instruments for investment purposes, which may expose the fund to a higher degree of risk and can cause investments to experience larger than average price fluctuations. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Due to the greater possibility of default an investment in a corporate bond is generally less secure than an investment in government bonds. Currency hedging is used to substantially reduce the effect of currency exchange rate fluctuations on undesired currency exposures. There can be no assurance that the currency hedging employed will be successful. Hedging also has the effect of limiting the potential for currency gains to be made. Select 50 is not a personal recommendation to buy or sell a fund. If you are unsure about the suitability of an investment you should speak to a Fidelity adviser or an authorised financial adviser of your choice.

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