REITs and inflation-linked bonds for the age of inflation

REITs and inflation-linked bonds are worth considering during inflation

Given that inflation will stay with financial markets for longer investors must address it in their portfolios. We argued for over a year that commodities are a must asset as a lot of the first wave inflation is coming from the supply side of the economy and in particularly commodities. We are also of the view that the world will be in a commodity super cycle during this decade driven by the green transformation, underinvestment in commodities over the past decade, urbanization, and the fallout from the war in Ukraine. Other themes that have done well during the past year’s inflationary regime are renewable energy, defence, logistics, India, and cyber security. All themes are still themes we like with India probably being the biggest short-term risk due to being an emerging market country with high equity valuations.

Outside equity themes many market participants talk about REITs (real estate investment trust) and inflation-linked bonds. REITs existed during the 1970s inflation period and were a catastrophe, but the real estate market and REITs have evolved a lot since the 1970s so it might be a stretch to expect something similar. Real estate is attractive during inflation because rents are linked to CPI indices and some rent agreements come with shorter duration which means they can catch up to inflation faster. Real estate valuations have also historically held up well during inflation and then there are no storage costs (but there are maintenance costs) which is used as argument for choosing real estate over gold during inflation; but even choose between the two, why not hold both assets? Bernstein data also show that US REITs have done well, even better than bonds and equities, in inflationary environments with inflation rates above 5% y/y. The key risks to REITs from rising interest rates, which we do expect given higher inflation, are summed up well by S&P Global:

Undoubtedly, rising interest rates pose challenges for REITs. All else being equal, higher interest rates tend to decrease the value of properties and increase REIT borrowing costs. In addition, higher interest rates make the relatively high dividend yields generated by REITs less attractive when compared with lower-risk, fixed income securities, which reduces their appeal to income-seeking investors.

Inflation-linked bonds are another instrument available to investors that want some inflation protection components in their portfolio. The US issued their first TIPS (Treasury Inflation-Protected Securities) in 1997 which are designed so that their interest payments rise with higher inflation as the principal of the bonds are adjusted for the CPI Index. Morningstar has a good description of inflation-linked bonds and one thing investors must be aware of is that inflation-linked bonds are often issued with longer maturity than the majority of nominal bonds which means that the interest rate risk is higher in the short-term, but longer term inflation-linked bonds will offer a better return after inflation than nominal bonds if inflation is trending higher.

The table below shows the five largest UCITS ETFs within each category.