Inflation in the UK is currently running at 9.4% a year, and could reach double digits later in 2022. These are levels not seen since the 1970s  and there’s no indication that they will fall significantly in the foreseeable future.

Inflation destroys returns for investors, so it's crucial to protect against it. Spurred by the rise in interest rates, energy prices, and post-Covid supply-chain disruptions, the UK now faces a major and, most likely, persistent inflation outbreak.

Inflation tends to have a negative impact on investment portfolios, especially those with fixed income assets such as bonds. As we’ve had a sustained period of below-normal inflation, we’ve grown used to such pressures having limited impact on fixed income investments. But as price rises approach double digits, there’s growing interest in asset classes with in-built inflation protection.

The inflation-linked debt market

For many fixed income investors, the UK government-issued, index-linked gilt has been the traditional instrument to protect returns from rising prices, with both coupon payments and final settlement pegged to inflation rates. However, there are growing opportunities to buy bonds with inflation-linked characteristics issued in private debt markets.

Inflation-linked bonds, even those within public markets, have limited liquidity as they are not included in traditional benchmarks for most corporate bond investors. This means those with longer investment horizons and lower liquidity needs may be able to access private debt issuance as superior yield by receiving excess compensation for the illiquidity.

Inflation-linked private market debt can be found in defensive, non-cyclical sectors such as utilities or infrastructure, which both have a low correlation to the economic environment.

Investors can also take extra comfort in forgoing that liquidity as, from a credit-risk perspective, the majority of inflation-linked private market debt can be found in defensive, non-cyclical sectors such as utilities or infrastructure, which both have a low correlation to the economic environment. For example, during the Covid pandemic, these sectors had some of the best performance across all asset classes.

Why issue debt in an inflationary environment?

It’s easy to understand why a bondholder would want to own bonds that have both coupon and/or principal repayments linked to inflation. But where are the advantages for the bond issuer? Well, for an issuer with a product or service that will also rise in price with inflation, this is a way to lock in a lower price for credit today, knowing that the future higher interest payment and debt repayment will be covered by the inflationary growth in revenue.

The bond issuer (the borrower) can lock in a lower coupon (interest repayment) on day one, but will have to return a higher principal (repayment of the bond) at maturity, as the principal is linked to inflation. Alternatively, the issuer can choose to make inflation-linked interest repayments, knowing that the value of their products or services will also rise in line with inflation, giving them certainty around their cashflows and revenues to repay the higher principal or repayments further down the line. The attractive prospect for corporate and infrastructure issuers is that they have lower initial borrowing costs, saving money to invest in other projects that aim to generate a higher return than the cost of borrowing.

High-water mark

One example of a company active in the inflation-linked infrastructure debt market is Anglian Water. As regulated utility companies are allowed to raise their prices in line with inflation indices, this makes inflation-linked debt issuance particularly attractive. Anglian’s debt also combines forward-looking environmental, social and governance (ESG) characteristics, where the capital raised will be used to tackle physical risks related to climate change. The company aims to make the east of England more resilient to the risks of drought and flooding. For borrowers, the benefits are doubled, as they gain protection from inflation while also contributing towards a fairer and more sustainable world. How borrowers address such environmental issues is now a fundamental part of credit assessment.

We believe it’s vital to evaluate the environmental and social risks of individual sectors as well as corporate leaders’ plans for management of these risks. Failure to incorporate these key risk evaluations into credit frameworks used for selecting investments could have serious consequences for capital lenders.

Real deals in the pipeline

UK regulated utilities are by far the largest sector issuing inflation-linked bonds, given their ability to increase the tariff in line with RPI (Retail Price Index) or CPI (Consumer Price Inflation). In the property sector, several REITs (Real Estate Investment Trusts) with inflation-linked rent are currently considering issuing inflation-linked bonds. The benefit is cheaper money initially, that can be used to make improvements to properties, followed by a bigger repayment later when more income has been raised due to rising rents because of the improvements and inflation.

Final thoughts...

The private debt market provides a rich seam of inflation-linked opportunities. Predictable, stable cashflows are on offer, along with the potential for higher, inflation-adjusted returns. In addition, many loans such as commercial real estate lending or infrastructure debt are secured against real assets with strong covenant protection, producing robust investment-grade ratings and considerably reducing the risk of default and capital impairment.

Overall, we see this area as an attractive way to diversify during the current, volatile market conditions. Private credit can potentially protect returns against spiking inflation, offer a lower risk of default versus comparable public corporate bonds and help investors better meet their investment and ESG goals.

Companies are selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance. Past performance is not a guide to future results.