How Real Is the Deflation Threat?
A Note about Risk: Investing involves risk, including the possible loss of principal. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Bonds may also be subject to call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest rate changes, the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Investing in derivatives involves the risk that the derivatives are or will become illiquid and that the counterparty may fail to perform its obligations. Because derivatives may involve a small amount of cash relative to the total amount of the transaction, the magnitude of losses from derivatives may be greater than the amount originally invested. Investing in commodity-linked derivatives and commodity-related companies may increase volatility. Stock values fluctuate in price so the value of your investment can go down depending on market conditions. Price movements may be influenced by weather and climate conditions, livestock disease, war, terrorism, political conflicts and economic events, interest rates, currency and exchange rates, government regulation and taxation. Investing in international securities generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs. Special risks are inherent to international investing, including those related to currency fluctuations and foreign, political, and economic events. These risks can be greater in the case of emerging country securities. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. No investing strategy can overcome all market volatility or guarantee future results.
TIPS (Treasury Inflation-Protected Securities) are Treasury securities indexed to inflation in order to protect investors from the negative effects of inflation. The principal of a TIP is adjusted according to the Consumer Price Index for all Urban Consumers (CPI-U). With a rise in the index, or inflation, the principal increases. With a fall in the index, or deflation, the principal decreases. Though the rate is fixed and paid semiannually, interest payments vary because the rate is applied to the adjusted principal. Specifically, the amount of each interest payment is determined by multiplying the adjusted principal by one-half the interest rate. Upon maturity, TIPS pay the original or adjusted principal amount, whichever is greater. Because TIPS are adjusted for inflation, a change in real interest rates (but not nominal interest rates) will affect the value of TIPS. When real interest rates rise, the value of TIPS will decline, and when real interest rates fall, the value of TIPS will rise.
The Consumer Price Index (CPI) measures the price changes for each item in a predetermined basket of goods and services, and the inputs are weighted according to their importance to consumers.
CPI Swaps reflect the movement in the headline CPI (including food and energy prices) and can appreciate in value if inflation expectations have increased since the swap was created and it is sold at a profit or there is a payment at maturity. If inflation expectations fall, the market value of the swap is likely to decline, which could lead to a loss. The connection of CPI swaps to actual changes in CPI means that the swaps have little correlation to nominal Treasuries and TIPS.
The Deutsche Bank 5-Year CPI Swaps Index is provided by Deutsche Bank AG and is based in U.S. dollars, provides intraday price frequency, and is subject to a one-day lag. It is designed to track the performance of five-year CPI swaps.
Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments, and exports less imports that occur within a defined territory.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
ABOUT THE AUTHOR
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.