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Fixed-Income Insights

Commodities, TIPS, and real estate may not provide protection. 

Investors who want to hedge against the risk of inflation traditionally have opted for commodities, real estate, and Treasury Inflation-Protected Securities (TIPS). But these strategies all have significant flaws that hamper their hedging capabilities.

In contrast, a portfolio comprising short-duration securities and CPI swaps1 holds the potential to hedge inflation risks without these drawbacks.

The Importance of Hedging Inflation
After the start of the Federal Reserve's quantitative easing (QE) program in November 2009, inflation became an overriding concern for many investors. These concerns were reflected in the price of inflation hedges such as gold, which rose from around $1,000 per ounce in September 2009 to more than $1,850 per ounce less than two years later.2 But despite the unprecedented monetary and fiscal stimulus in the wake of the subprime crisis (2008–09), inflation has remained subdued. Indeed, a case may be made that, in the short term, deflation is the greater threat.

Inflation, however, is one of the constants in the U.S. economy. Since 1945, the Consumer Price Index (CPI)3 has increased by an average of about 4.0% per year. In fact, declines have been rare and small, occurring in only three of those years, and each time by less than 1.2%.4

With the expansive monetary policy of the past few years, inflation is likely to eventually increase. History shows that loose money often results in pricing pressures, as it did most recently in the United States during the 1970s. The notable rise in the CPI that occurred early in that decade coincided with what many consider mistakes in monetary policy, mistakes in which the policy was too accommodative.

The accommodative monetary policies of the United States and other major developed markets are also, if not mistaken, at least unconventional. Though the Fed has recently begun to reverse its QE program, history may someday show that while the policy, which has more than quadrupled the Fed's balance sheet to $4 trillion, was necessary and prudent at the time, it eventually resulted in significant inflationary pressures. (See Chart 1.)

 

Chart 1. The Assets on the Federal Reserve's Balance Sheet Are Unprecedented
From week of December 18, 2002–January 8, 2014

Source: Federal Reserve.  

That inflation has remained quiescent so far, despite the unprecedented stimulus, may stem from the failure of the Fed's monetary stimulus to reach the real economy. Although bank reserves at the Fed have exploded with its purchases of Treasuries and mortgage-backed securities, the money supply (M1)5 has not expanded proportionately. Between August 2008 and November 2013 (latest available data for M1), bank reserves climbed from $44.6 billion to $2.5 trillion, or more than 5,400%, while M1, on the other hand, grew from $1.39 trillion to $2.6 trillion, or only about 88%.6

For pricing pressures to grow, the money supply will have to expand substantially, and for that to occur, banks will need to increase their lending. Though lending has slowed recently, commercial and industrial loans have been growing by an average of more than 9% year over year since December 2010, according to data from the Federal Reserve.7 The potential for credit creation to generate pricing pressures will only grow as the economy returns to full capacity, and with unemployment falling and factory utilization rising, the slack in the economy appears to be narrowing. (See Chart 2.)

 

Chart 2. Capacity Utilization Continues to Recover
Monthly capacity utilization, January 2000–November 2013

Source: Federal Reserve.  

 

With the economy continuing to move toward full capacity, inflation expectations may begin to rise, and according to Charles Plosser, president of the Philadelphia Fed, the public's perception of the Federal Reserve can play a role in these expectations. "One lesson learned during [the 1970s] is that inflation expectations can matter a great deal," Plosser said in a speech in 2009. "And if they become unanchored—that is, if the public comes to believe that the Fed will not do what is necessary to preserve price stability—then inflation can rise quickly regardless of the amount of so-called slack in the economy."8

In other words, critical to keeping expectations anchored is the Fed's credibility—credibility that, in some segments of the public, may have begun to crack in the wake of the financial crisis and repeated rounds of quantitative easing. A Bloomberg poll in 2010 showed that the Fed's reputation has suffered as a result of perceived lapses in regulatory oversight and failure to boost the economy. Nearly 40% of the public wants the Fed to be held more accountable, according to the poll.9 A more recent survey shows that the public questions the Fed's independence; 44% believe it is influenced by the president.10

The need for efficient inflation protection, therefore, is clear, given the nearly uninterrupted historical trend, the extraordinary monetary stimulus, and the questions in the public's mind about the Fed as an institution.

Traditional Inflation-hedging Strategies: How Well Do They Work?
Investors may consider commodities or real estate to hedge against rising prices, but these asset classes come with a variety of complicating factors.

In the case of commodities, it is not clear which ones—gold, silver, copper, oil, natural gas, lumber, wheat, or others—will provide the desired level of inflation protection. The choice is made more difficult by the idiosyncratic supply and demand factors of each market and by unforeseen factors such as geopolitical shocks and extreme weather.

Moreover, movements in these markets may or may not coincide with broader movements in prices. The strength of the Chinese economy, for example, can influence prices on a variety of commodities, regardless of the direction and pace of inflation in the United States. A similar dynamic can occur with real estate; values in the housing and commercial property markets may not necessarily track with the rate of inflation.

Moreover, the whims of these markets have led to price swings that, historically, have been far more volatile than changes in the rate of inflation. Indeed, the standard deviations11 on indexes tracking real estate investment trusts and commodities were several times higher than those tracking inflation and five-year CPI swaps from January 2004 through December 31, 2013. (See Chart 3.)

 

Chart 3. Commodities and Real Estate Can Be Volatile
Standard deviation of returns, January 1, 2004–December 31, 2013

Source: Ibbotson, Morningstar, Bureau of Labor Statistics (CPI), Barclays, Standard & Poor's, and Deutsche Bank.
1–3 Year Government Credit: Barclays Government Credit Aaa +1–3 Year Index.16
Inflation: Ibbotson Associates: SBBI—U.S. Inflation Index.17
5-Year CPI Swap: Deutsche Bank Breakeven 5-Year CPI.18
Treasury Bonds: Barclays U.S. Treasury Index.19
TIPS: Barclays U.S. Treasury TIPS Index.20
S&P 500: S&P 500 Index.21
Gold: S&P GSCI Gold Index.22
Commodities: S&P GSCI.23
REITS: S&P 500 U.S. REIT Index.24
Past performance is no guarantee of future results.
For illustrative purposes only and does not represent any specific Lord Abbett fund or any particular investment.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. An investor may not experience similar results.
Investing in commodity-related companies may increase volatility. 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. 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. 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. Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.  

 

With regard to TIPS, which may be the most commonly used inflation-protection product on the market, a number of drawbacks make them a less than optimal choice. First, they reflect real yields—or nominal Treasury yields minus inflation expectations (as implied by the spread between the Treasury yield and the TIPS yield)—and because nominal yields have been so low, real yields have at times been negative. By accepting negative yields, investors are essentially forgoing income for the potential of principal appreciation at maturity. (See Chart 4.)

 

Chart 4. Yields on TIPS Remain Low
Nominal yields on 10-year Treasuries versus TIPS, January 2004–January 2014

Source: Bloomberg 10-Year Treasury Index,25 and Bloomberg 10-Year TIPS Index.26
Past performance is no guarantee of future results.
For illustrative purposes only and does not represent any specific Lord Abbett fund or any particular investment.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. An investor may not experience similar results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Treasury Inflation-Protected Securities (TIPS) are Treasury securities that are indexed to inflation in order to protect investors from the negative effects of inflation. TIPS are considered an extremely low-risk investment since they are backed by the U.S. government and since their par value rises with inflation, as measured by the Consumer Price Index, while their interest rate remains fixed.

 

Because of these historically low yields, TIPS may not provide effective income protection. Consider a situation in which inflation is running at 2% a year. In that case, the principal on a TIPS issue would rise by 2%, but given the exceptionally low yields on Treasuries, this adjustment would produce essentially no increase in income. Indeed, for 10-year TIPS with a coupon of 0.75%, a 2% increase in the principal would increase the annual interest payment by only $15 per $100,000 of par value.12

Second, this minimal adjustment to income underscores TIPS' well-known duration risk and positive historical correlation with Treasury securities. For example, when the yield on the 10-year Treasury note jumped by 118 basis points (bps)13 between October 14, 2010, and February 10, 2011, Treasuries lost 4.45%.14 During the same period, a benchmark TIPS index posted a loss of 5.27%.15

Third, the minimal increase in interest income provided by TIPS means the amount available to be reinvested will be small, meaning that investors will be less able to capitalize on the higher coupon rates available in a rising-rate environment.

An Alternative to the Alternatives: Hedging Inflation with CPI Swaps
Clearly, the traditional strategies come with a host of drawbacks. Hedging inflation via a portfolio of short-duration securities overlaid with CPI swaps, on the other hand, may offer a more efficient alternative.

Unlike TIPS, CPI swaps have a strong negative historical correlation (-0.50) with Treasuries. (See Chart 5.) When, as mentioned above, the yield on 10-year Treasuries rose 118 bps between October 14, 2010, and February 10, 2011, and both Treasury notes and TIPS experienced losses, 10-year zero-coupon CPI swaps posted a positive return of 4.3%.27

 

Chart 5. Unlike TIPS, CPI Swaps Have Historically Been Negatively Correlated with Treasuries
Correlation with Barclays U.S. Treasury Bond Index, January 1, 2004–December 31, 2013

Source: Morningstar, Barclays Capital, and Deutsche Bank.
Past performance is no guarantee of future results.
For illustrative purposes only and does not represent any specific Lord Abbett fund or any particular investment.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. An investor may not experience similar results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
Treasury Inflation-Protected Securities (TIPS) are Treasury securities that are indexed to inflation in order to protect investors from the negative effects of inflation. TIPS are considered an extremely low-risk investment since they are backed by the U.S. government and since their par value rises with inflation, as measured by the Consumer Price Index, while their interest rate remains fixed. Investing in inflation-linked 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. 

 

Under inflationary conditions, capital appreciation using this method is likely to come from CPI swaps that overlie the portfolio. Like TIPS, these instruments reflect the movement in the headline CPI (including food and energy prices). CPI swaps can appreciate if inflation expectations have increased since the swap was created. (See below for more on CPI swaps.)

Moreover, by keeping to short-term instruments, a portfolio can reduce the potential downside risk to principal. A duration of around two years is feasible and well below the average duration in Morningstar's inflation-protected bond category, which recently was about 6.5 years (latest available as of January 16, 2014).28

CPI swaps, like all investments, come with some risk. Liquidity is one potential risk, and there is a possibility that a counterparty to a swap contract could default. Both parties to a swap contract normally conduct due diligence to discover whether the financial health of the other party is in question. In addition, both parties are normally required to post collateral for any amounts they may owe.

Conclusion
Given that inflation has, historically, presented a risk to U.S. investors, and that higher inflation is likely in the future, hedging that risk in an effective manner is critical. The traditional means of hedging, however, come with risks of their own that may undercut their hedging capability. Commodities and real estate are highly volatile and subject to idiosyncratic supply and demand factors, while TIPS carry significant duration risk and high correlations with Treasury securities. On the other hand, a portfolio of short-duration securities, combined with CPI swaps, would appear to reduce these risks while offering the possibility of capital appreciation.

 

Under the Hood of CPI Swaps

Interest-rate swaps consist of a contract between two parties that stipulates that one party will make fixed payments while the other will make variable payments.

CPI swaps are a type of interest-rate swap in which the fixed payment is based on the current, expected rate of inflation and the variable payment is based on the actual rate of inflation. The actual rate of inflation is measured by the cumulative change in the headline Consumer Price Index (CPI), which includes food and energy. The expected rate of inflation, which determines the fixed-payment side of the contract, is estimated using TIPS breakeven rates, existing CPI swap rates, or other market data. (The TIPS breakeven rate is the difference between the yield on a TIPS and the yield on Treasury debt of the same maturity.)

The amounts of the agreed-upon payment are determined by the fixed or variable rate multiplied by the size, or notional amount, of the contract.

CPI swaps come in a few varieties, the most common of which is a zero-coupon swap. These are similar to zero-coupon bonds in that the only payment occurs when the contract matures. Thus, there is no cash commitment when a party enters a zero-coupon swap agreement or during the life of the contract. An investment strategy can therefore enter a notional amount that matches the size of an underlying portfolio.

A Hypothetical Example: Three Scenarios
Suppose inflation is expected to average 2.5% over the next five years. Parties interested in hedging against a higher actual rate of inflation would seek a swap in which they would pay the expected rate and receive the actual rate of inflation. They could enter a five-year, zero-coupon CPI swap contract, in which they would pay 2.5% compounded over the life of the contract. In exchange, they would receive the actual, cumulative change in CPI over the next five years.

The notional value of the fixed portion
   = $10 million @2.5% interest over five years
   = ($10 million) * (1.025)5 = $11,314,082.

When the zero-coupon CPI swap reaches maturity, there are three potential scenarios. In Scenario 1, the actual change in the CPI is 2.5%, matching the rate that was expected when the contract was created, so no money changes hands.

In Scenario 2, the change in the CPI is greater than 2.5%, so the CPI contract will generate a gain. If the CPI rises by 3.5%, for example, the value of the floating portion of the contract will equal:
   $10 million @ 3.5% over five years
   = ($10 million) * (1.035)5 = $11,876,863,
   for a gain of $562,781, or 5.6%.

In Scenario 3, the change in the CPI is less than 2.5%, so the CPI swap will produce a loss. If the CPI rises by just 1.5%, for example, the value of the floating portion will equal:
   $10 million @ 1.5% over five years
   = ($10 million) * (1.015)5 = $10,772,840,
   for a loss of $541,241, or -5.4%.

The market value of a contract may change daily as it is marked to market. If inflation expectations increase, the value is likely to rise; if inflation expectations fall, it is likely to decline.

The secondary market for zero-coupon CPI swaps is considered to be liquid, with about $100–150 million in average daily volume. A portfolio of about $300 million could sell 100% of its swaps exposure in two to three days.

In an environment of low volatility, the average bid/ask spread29 on a CPI swap trade of up to $25 million is about 2 bps, about the same as a similar trade of investment-grade corporate bonds. The spread can widen during periods of volatility, however.

Historically, inflation cycles run about seven to eight years, and CPI swaps with tenors of 10 years or less trade with ample liquidity.

The examples above are hypothetical and for illustrative purposes only.

 

1 CPI swaps are a type of interest-rate swap in which one party pays a fixed interest rate based on inflation expectations, and the other party pays a variable rate based on inflation expectations. Inflation swaps are often based on the Consumer Price Index.
2 www.kitco.com; accessed September 30, 2013.
3 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.
4 Bureau of Labor Statistics.
5 M1 is a narrow definition of the money supply. M1 includes currency in circulation, demand deposits (checking accounts), and Negotiable Order of Withdrawal (NOW) accounts. NOW accounts are interest-earning accounts that allow the depositor to write checks against the money deposited.
6 U.S. Federal Reserve, Aggregate Reserves of Depository Institutions - H.3; and Money Stock Measures - H.6.
7 U.S. Federal Reserve; Selected Assets and Liabilities of Commercial Banks in the United States - H.8
8 Charles Plosser, "Demystifying the Federal Reserve," speech at Lafayette College, September 29, 2009.
9 Joshua Zumbrun, "Majority of Americans Say Fed Should Be Reined In or Abolished," www.bloomberg.com, December 9, 2010.
10 "44% Think Fed Chairman Influenced by President," www.rasmussenreports.com, September 28, 2012.
11 Standard deviation is a measure of volatility. Applied to an asset's return, it provides a measure of the range of those returns. A higher standard deviation means a greater range of returns.
12 Initial interest payment: $100,000 x 0.75% = $750. Interest payment with 2% increase in principal: $102,000 x 0.75% = $765.
13 A basis point is one one-hundredth of a percentage point.
14 Source: Barclays.
15 Source: Barclays.
16 The Barclays Government Credit Aaa+ Index is a subset of the Barclays Government Credit Index, which tracks investment-grade government debt.
17 The Ibbotson Associates SBBI-U.S. Inflation Index is an inflation indicator based on the Consumer Price Index (CPI) that measures the change in the cost of a fixed basket of products and services, including housing, electricity, food, and transportation. CPI values reflect midmonth price levels; thus, Ibbotson Associates estimates the most current month by taking the average rate of the previous two months to match month-end asset class returns.
18 The DB US CPI Breakeven Inflation 5-Year Swap indexes allow investors to track the performance of five-year inflation swaps. These measure the performance of holding an inflation receiver, breakeven payer swap. The inflation swaps are based on the U.S. CPI Urban Consumers Index.
19 The Barclays U.S. Treasury Index. The Barclays U.S. Treasury Index measures the performance of the U.S. Treasury bond market. Using market-capitalization weighting and a standard rule-based inclusion methodology, the index accurately reflects the performance and characteristics of the Treasury market.
20 The Barclays U.S. TIPS Index. The Barclays U.S. Government Inflation-Linked Bond Index (U.S. TIPS) measures the performance of the TIPS market. TIPS form the largest component of the Barclays Global Inflation-Linked Bond Index. Inflation-linked indexes include only capital indexed bonds with a remaining maturity of one year or more.
21 The S&P 500 Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.
22 The S&P GSCI Gold is a subset of the S&P GSCI, which covers price movements of commodities markets.
23 The S&P GSCI is an index that price movements of commodities markets. The index is global and weighted by production volumes.
24 The S&P 500 REIT Index is a subset of the S&P 500 Index covering real estate investment trusts.
25 The H15T10Y Index is a Bloomberg index that indicates the yield on 10-year Treasury bills. The source of the data is the U.S. Federal Reserve.
26 The U.S. Generic Government TII 10 Year Index is a Bloomberg index that measures yields on 10-year TIPS.
27 CPI swap return data are from Bloomberg.
28 The Morningstar Inflation-Protected Bond Category comprises strategies designed to provide protection against inflation. All information referring to Morningstar data is from Morningstar.
29 A bid/ask spread is the difference between an asking price and a bid price. It is a measure of the difference between the highest price a bidder will pay and the lowest price at which a seller will sell.

 

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The Fund seeks to deliver investment returns that exceed the rate of inflation in the U.S. economy and current income by investing primarily in inflation-linked derivatives and inflation-indexed fixed income securities.

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