As inflation soars to levels not seen in years, the costs of hedging against it via traditional liquid market securities are becoming prohibitively expensive. Real assets might offer institutional investors a better option, argues Luke Layfield.
Read this article to understand:
- Why the cost of hedging inflation is soaring
- Why real assets offer an alternative way of achieving this goal
- The inflation-hedging credentials of different types of real asset
For years it had been assumed inflation had been tamed. Initially, that was because of actions taken by the Federal Reserve and other major central banks. More recently, the combined forces of globalisation and technological innovation drove manufacturing costs inexorably lower as jobs were shipped overseas or automated.
However, with the world awash with cheap money, global demand has risen strongly over the past year and a half. With companies simultaneously struggling to adapt to buckling supply chains, four decades after it was supposedly slayed, the dragon of inflation has returned with a vengeance.
The US consumer price index rose seven per cent year-on-year in December, a 40-year high. In the euro zone, inflation rose to five per cent in December, its highest level since the single currency was created more than two decades ago; meanwhile in the UK, headline inflation surged to 7.5 per cent in December, a three-decade high.
Opinion is divided as to where inflation is heading next. Perhaps understandably, given central banks’ efforts to soothe financial markets, there are those who see little cause for alarm. They expect inflationary pressures to abate as the after-effects of the pandemic begin to ease, drawing comfort from central banks’ insistence they will not hesitate to tighten monetary policy more aggressively if necessary.
Others are less convinced, however. For them, shrinking workforces as populations age and ongoing deglobalisation could mean inflation proves far less transitory than central banks expect. Moreover, policymakers have good reason to be more tolerant of inflation than they are letting on publicly.
Governments have had to borrow a huge amount due to the pandemic and it seems, unlike in the aftermath of the global financial crisis, austerity will not be the preferred method of reducing debt. In the UK, for example, it is forecast that by the end of March, net government debt will have swelled by £576 billion since the start of the pandemic to nearly £2.4 trillion.1 Furthermore, the Office for Budget Responsibility forecasts annual government borrowing is unlikely to return to pre-pandemic levels for five years.2
It is hard to see how this additional borrowing can be repaid via either spending cuts, tax rises, or a combination of the two. Not only would austerity be politically unpalatable, assuming a one per cent rise in taxes across the board, it would take three quarters of a century just to pay back the additional borrowing caused by the pandemic.3
The risk is policymakers become more tolerant of inflation as a means of reducing debt; witness the softening of inflation targets by both the US and European central banks since the start of the pandemic.
Inflation outlook highly uncertain
While it remains to be seen whether inflation proves transitory, the outlook is undeniably more uncertain than at any time in the past 40 years. However, while pension schemes and other long-term investors are watching closely, the problem they face is the huge supply and demand mismatch for liquid assets able to hedge against inflation.
There is a huge supply and demand mismatch for liquid assets able to hedge against inflation
UK defined-benefit pension schemes have £2 trillion of liabilities, but there are barely £600 billion worth of index-linked gilts. This mismatch is compounded by demand from other investors who need to hold the debt to match long-term liabilities linked to inflation.
Although there is nothing new in this imbalance between demand for and supply of inflation protection, the situation is deteriorating. Having performed strongly recently, many pension schemes are looking to lock-in those gains and hedge away some risk. At the same time, supply is tightening. There are few natural borrowers looking to pay out index-linked returns, constraining banks’ willingness to offer protection via the swaps market. Meanwhile, the UK government has clearly favoured issuing conventional bonds, no doubt aware that, unlike index-linked debt, their value can be inflated away.
Whereas in the financial year to March 2020, index-linked debt accounted for 19 per cent of gilts sold, in the 21 months since they have comprised little more than seven per cent of sales.4
Inflation hedges are expensive
As a result, the cost of hedging against inflation via traditional liquid market instruments such as index-linked gilts and inflation swaps has risen appreciably. Market expectations of inflation over the next ten years, as measured by the difference between conventional and index-linked gilt yields, currently stands at 4.02 per cent, having hit a record high of 4.22 per cent in December. The cost of hedging ten-year inflation via swaps is 4.22 per cent, also just below a recent record high.
Figure 1: UK inflation protection costs hit record high
Source: Bloomberg, as of January 10, 2022
This presents pension trustees with a dilemma: bet the rise in inflation will be short lived and market-derived expectations are excessive or sacrifice a significant amount of return to protect against the risk of more prolonged or even higher inflation.
Real assets are a useful addition to the toolkits of those looking to hedge inflation risk
Against this backdrop, real assets – private market investments where the investor has security over a physical asset such as an office building, airport or wind farm, and not merely a contractual relationship with a counterparty – are a useful addition to the toolkits of those looking to hedge inflation risk.
Many of these real assets can be structured to provide secure, long-term contractual cashflows and, since the drivers of investment returns are often uncorrelated to more liquid markets, they can help to diversify portfolios. While real assets involve some extra risks relative to liquid market instruments, such as reduced liquidity and, in some cases, variability in cashflows or counterparty credit quality, investors are compensated by higher prospective returns.
A better way to hedge inflation risk?
As varying degrees of inflation protection are built in, they potentially offer pension schemes an attractive way to hedge inflation and match liabilities. The long-term inflation linkage is commonly found in three areas: subsidised renewable infrastructure, long-lease real estate, and inflation-linked private debt.
Subsidised renewables are at the upper end of the risk-return spectrum
Subsidised renewables are at the upper end of the risk-return spectrum. Here, investors sell energy at a guaranteed price, backed by the government, and linked to inflation. Although the amount of income generated depends on the operational output of that asset, this risk is mitigated since these are established technologies with limited variability of output.
In the middle of the risk-return spectrum is long-lease real estate. It is structured so most, if not all, of the value of the asset is in a long-term lease to a strong counterparty, with rent reviews linked directly to inflation. These can be on either an amortising basis, where the tenant retains ownership of the property, to provide a pure bond-like return, or on a more traditional reversionary basis where investors manage the risks and rewards of property ownership beyond the end of the lease. The asset class also includes commercial ground rents with a long duration, where income security is created through a structure backed by a significant amount of collateral.
Private debt provides pure contractual bond cashflows with low volatility
Private debt is at the least risky end of the spectrum. It provides pure contractual bond cashflows with low volatility. The focus of index-linked debt in this market tends to be on infrastructure, including loans to fund public and/or private sector investment in schools, hospitals, utilities, roads, bridges, airports, or renewables. While its strong cashflow-matching credentials means a lower return, private debt still offers a significant pick-up relative to public market debt, largely reflecting an illiquidity premium.
Based on current prices, we expect additional returns over long-dated index-linked gilts of between four and five per cent from subsidised renewables, between 2.5 and five per cent from real estate long income depending on the investment structure, and around 1.5 per cent from index-linked infrastructure debt.
Figure 2: Expected return versus index-linked gilts (per cent)
Source: Aviva Investors, as of December 2021
A menu of options
In selecting from the menu of real assets options, pension schemes should consider their key investment objectives and match these to the asset class that best meets them. While expected returns rise as investors accept greater cashflow-matching risk, it should be stressed that all these asset classes represent secure, long-term income streams where the majority, or all, of the income is contractually guaranteed.
Private debt linked to inflation will tend to be fully indexed
The ability of these investments to hedge inflation risk varies. Private debt linked to inflation will tend to be fully indexed; even though most of the revenue from subsidised renewables is index-linked, some of the cashflow is subject to fluctuations in power prices – albeit this can be hedged where necessary. As for real estate long income, whereas amortising leases tend to index annually with income paid quarterly, some other long leases are only indexed every five years.
While caps and floors limit the degree of indexation available from many of these assets, this should not prove a barrier to investment, especially as scheme liabilities are often capped. Moreover, as the level of inflation protection afforded declines, expected returns tend to rise.
The main drawback to investing in real assets is their relative illiquidity. While the returns available are often attractive relative to those in more liquid markets, they are not as easy to crystallise since they are not tradable on a centralised exchange. Illiquid assets also take longer to access and build an allocation in.
With market inefficiency comes opportunity
Instead, assets are traded privately with every deal being bespoke and dependant on managers with specialist capabilities and networks. The opaque nature of these markets can create inefficiencies, but this also creates opportunities to exploit mispricings and an advantage for first movers who can deploy funds effectively and efficiently.
The opaque nature of real assets creates opportunities to exploit mispricings
The appeal of these assets is also influenced by prevailing supply and demand factors. On the supply side, for example, subsidies for new renewable energy assets have been removed from established technologies such as wind and solar. That means new allocations must focus on existing stock being traded or new technologies benefitting from subsidies, such as anaerobic digestion. For those with a higher risk tolerance, energy-from-waste and fibre broadband assets can enhance returns while offering an element of inflation linkage, albeit not contractual.
On the demand side, competition for real assets, which affects the time taken to deploy new capital, varies. Index-linked private debt investments, for example, are already in high demand from insurers, making it difficult to build a sizable allocation. As for exiting investments, this too can be difficult and present a challenge for a mature pension scheme targeting a buy-out in the near term.
Growing demand is making them more readily tradable
However, while these private assets are less liquid, growing demand is making them more readily tradable. This, combined with uncertainty over the outlook for inflation and the cost of traditional liquid market hedging instruments, offers a clear rationale for adding real assets to investment portfolios.