Hedging inflation risk: A practical guide


Hedging inflation risk: A practical guide

For three decades global inflation was on a downward trend. But in recent months inflation has risen sharply. The question which many investors are asking is whether this higher inflation rate is transitory or not?


This article summarises our views on the inflation outlook and considers how investors can manage their inflation risk. We focus on an analysis of asset-class real returns over different historical inflationary environments and examine the implications for investment portfolios.

 

Executive Summary

We expect inflationary pressures to be transitory

Inflation remains one of the most difficult economic variables to forecast. Nonetheless, we believe that the currently high inflation rates can be explained by temporary effects. We do not believe the structural factors are in place to drive sustained price increases over multiple years.

Understand your inflation sensitivity

Most investors have some level of sensitivity to inflation. But the types of inflation risk that investors face can be different, so the solution for hedging inflation risk may differ per investor.

For investors with long-term inflation linked liabilities

Sensitivity to long-term inflation breakeven rates can be hedged using inflation-linked bonds or inflation swaps, matched to the desired sensitivity profile.
In practice, there are some potential issues with inflation hedging, such as basis risk, inflation caps and floors and affordability, which investors need to account for when setting their hedging strategy.

Asset class real returns

Commodities have historically performed well over shorter periods when inflation has risen sharply. Over the longer term, most asset classes have produced real returns in different inflationary environments. However, given the current low yield environment it is unlikely that nominal government bond returns will keep pace with inflation.

Inflation and correlations

Although a full study of the impact of asset classes correlations and inflation is beyond the scope of this paper, historically the diversification benefits of a simple equity and bond portfolio has been reduced at times of higher inflation. We recommend that a full asset-liability study is carried out to investigate this further.

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More about the authors

Gerard Moerman Head of Fixed Income, LDI and Investment Solutions

Gerard Moerman, PhD, is head of fixed income, LDI and investment solutions.


Ritchie Thomson Senior Responsible Investment Associate

Ritchie Thomson is a senior responsible investment associate responsible for analyzing and monitoring key climate change issues facing companies and industry sectors.


Peter Spijkman Senior Investment Strategist

Peter Spijkman joined Aegon Asset Management in 2012. He is a senior Investment Strategist in the Fiduciary Services and Investment Solutions team.



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