Ep. 122: The Role of Linkers in Portfolio Construction, with Chris Clothier
Sep 24, 2024
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In this discussion, Chris Clothier, Co-CIO of CG Asset Management, shares his expertise on the role of inflation-linked bonds in portfolio construction. He delves into their advantages and risks, emphasizing how they provide inflation protection during economic downturns. The conversation also touches on macroeconomic trends reshaping strategies, the implications of globalization's end, and how historical connections to inflation can inform today's investing. Clothier’s insights are invaluable for anyone looking to navigate the complexities of modern finance.
Inflation-linked bonds protect against inflation while diversifying portfolios, ensuring investors maintain purchasing power and potentially outperform nominal bonds during high inflation.
These bonds present an asymmetrical risk profile, offering significant upside potential in inflationary scenarios while providing a guaranteed return of the original investment during deflation.
Deep dives
Understanding Inflation-Linked Bonds
Inflation-linked bonds, often referred to as linkers, play a significant role in diversifying a portfolio. They provide protection against inflation, which is considered a major threat to investors' returns. These bonds work by adjusting their principal according to inflation rates, ensuring that investors maintain their purchasing power. Moreover, investing in these bonds can yield better returns than nominal bonds during periods of high inflation, especially since historical data indicates that nominal assets typically struggle in such environments.
The Asymmetry of Inflation Risk
One of the key insights regarding inflation-linked bonds is their asymmetrical risk profile. In an inflationary scenario, the potential upside for these assets significantly outweighs the downside, as they offer a par floor, which guarantees the return of the original investment even during periods of deflation. This characteristic is valuable because inflation tends to have a fat right tail, suggesting that while it can spike sharply, deflation is less common. As a result, inflation-linked bonds present a unique opportunity for investors to mitigate the risk of losing purchasing power during uncertain economic times.
Portfolio Construction Insights
When constructing a portfolio, investors should consider the macroeconomic outlook, particularly regarding inflation and growth. Inflation-linked bonds serve as a stabilizing asset class, especially in high inflation and low growth environments, often referred to as stagflation. By incorporating these bonds into an investment strategy, one can counterbalance the risks associated with equities, especially when both stocks and nominal bonds may struggle. It is essential to align the bond allocation with the overall risk appetite, ensuring a robust defense against potential inflationary pressures.
Global Perspectives on Inflation-Linked Bonds
Investors, especially those outside the US, face unique challenges when considering global inflation-linked bonds. While US investors may find it simpler to stick with domestic bonds due to their favorable real yields, foreign investors can tap into global opportunities. It's crucial for them to be cautious about currency risk and to consider investing in unhedged inflation-linked bonds to capture the full benefits. An understanding of how global inflation dynamics interact with local economies can help investors make informed decisions that enhance their portfolio's resilience against inflation.
The Inflation Guy Podcast welcomes a special guest this week: Chris Clothier, co-CIO of UK asset manager CG Asset Management. Together, Chris and the Inflation Guy discuss how they think about inflation-linked bonds in the context of a portfolio: how to think about their return; different aspects of their risk; and what role/benefit they play in the construction of an 'all-weather' portfolio.