Inflation: Is There Opportunity in Not-So-Great Expectations?
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 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. 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. No investing strategy can overcome all market volatility or guarantee future results.
Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
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.
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.
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.
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.
The "core" PCE Price Index is defined as personal consumption expenditures (PCE) prices excluding food and energy prices. The core PCE price index measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices to reveal underlying inflation trends. Food prices consist of those included in the PCE category of “food and beverages purchased for off-premises consumption.” Prices included in the PCE category “food services and accommodations” are not included in the “food” price index because these services prices tend to be far less volatile than those for food commodities such as meats, fresh vegetables and fruits. Energy prices consist of those included in the PCE categories of “gasoline and other energy goods” and of “electricity and gas” utilities.
Correlation is a statistic that measures the degree of association between two variables.
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.
The Bloomberg Commodity Index is made up of 22 exchange-traded futures on physical commodities. The index represents 20 commodities, which are weighted to account for economic significance and market liquidity.
The Deutsche Bank U.S. 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.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
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.