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Market View

CPI swaps, combined with a strategic allocation of short-term bonds, represent a more direct approach to targeting inflation—without the interest-rate risk of Treasury inflation-protected securities.

 

In Brief

  • Robust U.S. labor-market data, along with a climb in inflation expectations, have investors once again considering the possibility of a sustained rise in U.S. inflation.
  • How, then, might investors protect their portfolios? Treasury inflation-protected securities (TIPS) are the most common approach to inflation protection, but they have one major drawback: a heightened sensitivity to rising interest rates.
  • In contrast, a portfolio of swaps tied to the U.S. Consumer Price Index may provide a more direct hedge against inflation risk, without the duration exposure of TIPS.

 

In previous Market Views, we reviewed strategies that may help diversify core bond allocations, including ultra-short strategies, short-duration credit, and bank loans, with the latter asset class in particular drawing increased attention as interest rates have been rising.  This week, we revisit a related topic: With U.S. economic growth continuing at a steady pace, and the labor market strengthening, how can fixed-income investors prepare for a potential increase in inflation?

Inflation in the United States has been well contained in recent years, with the U.S. Federal Reserve’s (Fed) preferred inflation measure, the Core Personal Consumption Expenditures Price Index, remaining below 2.0% for most of the past six years.  However, as the U.S. economy continues to grow, that may change.  For example, the latest U.S. employment report indicated that the unemployment rate dropped, to 3.8%, the lowest level since 2000, and near its lowest reading in 50 years. 

To be sure, despite tight labor markets, wage pressures have been relatively modest to date. But Giulio Martini, Lord Abbett director of strategic asset allocation, notes that very strong labor demand, reflected in record-high data on U.S. job openings, is consistent with a much tighter labor market than the current unemployment rate indicates. “If headline indicators of labor market slack suddenly tighten from already low levels, it could trigger a sharp increase in inflation expectations,” he says.

And while inflation has remained at or below the Fed’s 2% target, recent reports have shown an uptrend in as-reported consumer prices. (See Chart 1.) This, coupled with a rise in inflation expectations to multiyear highs (as depicted in Chart 2), makes it clear that a potential sustained upturn in inflation is increasingly on the market’s radar.

 

Chart 1. Two Key Measures Show As-Reported Inflation Trending Upward in Recent Months
Headline Consumer Price Index (CPI) and core CPI (both in percent), April 30, 2014–April 30, 2018

Source: U.S. Bureau of Labor Statistics. Core CPI excludes food and energy prices.

Chart 2. Inflation Expectations Have Been Rising
Five-year CPI swap breakeven rates (in percent), June 7, 2013–June 1, 2018

Source: Bloomberg. Five-year inflation expectation is represented by the five-year zero coupon inflation swap rate. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Returns during other times may vary. Due to market volatility, the market may not perform in a similar manner in the future. Like all investments, inflation derivatives involve specific risks that should be carefully evaluated. Although these securities are more complex than typical stock and bond investments, they entail similar liquidity and potential default considerations.
Past performance is no guarantee of future results.  

 

Investors who want to protect their portfolios (particularly fixed-income holdings) from the negative effects of rising prices for goods and services typically turn to inflation-protection strategies.  However, as we have highlighted before, the most common inflation-hedging strategies are focused on Treasury inflation-protected securities (TIPS), which might not provide the protection that investors expect.

TIPS are a type of U.S. Treasury security that is indexed to inflation: the principal of a TIP is adjusted based on the change in the U.S. Consumer Price Index (CPI).  While the inflation adjustment can help combat the impacts of inflation, TIPS do have a duration component.  In fact, the largest exchange-traded fund (ETF) that tracks the most commonly used TIPS benchmark, the Bloomberg Barclays U.S. TIPS Index, now has an effective duration of 7.6 years.  Given that the TIPS index is comprised of longer-duration, government-related securities, the performance of these inflation-protection securities historically has been highly correlated with U.S. Treasuries and other high-quality fixed-income securities. As a result, during periods of rising interest rates, investors in TIPS have been disappointed with their experience, realizing the negative effects of greater interest-rate sensitivity just when they were expecting protection. In one well-known example, in the wake of a sharp increase in interest rates in 2013, the Bloomberg Barclays U.S. TIPS Index posted a return of -8.6% for that calendar year.

Table 1 summarizes how rising rates have affected returns across several fixed-income indexes year to date (through June 8, 2018).  Duration has been a major driver of fixed-income returns this year, with the broad bond-market benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index, down more than 2.0%. Bonds with low duration, such as short-term corporates, are basically flat, while floating-rate securities, which have little to no duration exposure, have had positive returns.  Investment-grade corporate floating-rate notes are up 1.1%, while below-investment-grade bank loans are higher by 2.5%, as limited duration has limited the impact of rising rates, and their current income has led to positive total returns.

 

Table 1. Duration Has Been a Headwind to U.S. Fixed-Income Returns in 2018
Total return, year to date through June 8, 2018

Source: Bloomberg. “Bloomberg Barclays Aggregate” refers to the Bloomberg Barclays U.S. Aggregate Bond Index. U.S. Treasuries are represented by the Bloomberg Barclays U.S. Treasury Index. U.S. TIPS are represented by the Bloomberg Barclays U.S. TIPS Index. Short-term corporates represented by the ICE BofAML 1-3 Year U.S. Corporate Index. High yield is represented by the ICE BofAML High Yield Index. Investment-grade floating-rate notes are represented by the Bloomberg Barclays Investment-Grade Floating-Rate Note Index. Bank loans are represented by the Credit Suisse Leveraged Loan Index.

Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged and are not available for direct investment. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. While U.S. Treasury or government-agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates.  Diversification does not ensure a profit or protect against a loss in a declining market.

 

Is there, then, a way for bond investors to mitigate the harmful effects of rising inflation on portfolio returns without taking on undue interest-rate risk? One strategy they might consider employs a portfolio of professionally managed swaps tied to the CPI. By capturing movements in inflation expectations and changes in headline CPI, the value of CPI swaps is more directly targeted toward inflation, without the interest-rate exposure of a traditional TIPS strategy. [Note: Both CPI swaps and the CPI adjustment for TIPS are based on headline CPI, which includes food and energy, not the core CPI measurement.] Unlike TIPS, CPI swaps historically have a negative correlation with Treasuries (see Chart 3), which may lead to more efficient diversification for investors’ fixed-income holdings.

 

Chart 3. Diversification Consideration: CPI Swaps Zig When Treasuries and Core Bonds Zag
Five-year correlation coefficients with indicated benchmarks, as of May 31, 2018

Source: Morningstar and Bloomberg.
CPI swaps represented by the Bloomberg Inflation Swap USD 5-Year Zero Coupon Index. TIPS (Treasury inflation-protected securities) are represented by the Bloomberg Barclays U.S. TIPS Index. Bloomberg Barclays Aggregate” refers to the Bloomberg Barclays U.S. Aggregate Bond Index.  U.S. government bonds are represented by the Bloomberg Barclays U.S. Government Index.
With CPI swaps, TIPS, or as with any other securities, investors should remember that past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Diversification does not ensure a profit or protect against a loss in a declining market.

 

One way to achieve this could be by combining a diversified portfolio of short-term bonds with an overlay of CPI swaps. Here’s how it might work: If actual inflation matches the expected level per the swap agreement, the CPI swap will have no impact on returns. In this case, the strategy will earn the returns of the underlying bond portfolio.  As inflation and inflation expectations increase, the value of the CPI swap will increase and add to the returns of the underlying bond portfolio. Conversely, if inflation expectations decrease, the value of the swap will detract from the underlying bond portfolio. It is important to note that in certain environments when inflation expectations are falling sharply, CPI swaps may generate negative returns. However, periods of falling inflation expectations and interest rates are generally very positive for high-quality bonds.

Given the potential duration risk in TIPS, many investors have looked to shorter-duration TIPS to get inflation protection without the interest-rate risk of the broader TIPS category (as represented by the Bloomberg Barclays U.S. TIPS Index). While this approach limits duration exposure (the largest ETF tracking a short-term TIPS index now has an effective duration of 2.7 years), it offers little opportunity for income.  For example, while the real (inflation-adjusted) yield on the benchmark five-year TIPS security recently was 0.7% (a big increase from the yield of -0.5% in mid-2016), a strategy combining CPI swaps with a short-duration bond portfolio may provide more attractive income, while maintaining a low-duration exposure to limit rate risk, and offer the potential to benefit from rising inflation.

Summing Up
The qualities of CPI swaps discussed above could make them an important part of an alternative inflation-protection strategy. CPI swaps represent more of a “pure play” on inflation protection, especially compared to traditional hedges such as real estate and commodities. By combining a portfolio of short-term, credit-sensitive bonds with an overlay of CPI swaps, asset managers have the potential to create a portfolio with a higher yield and lower duration than a traditional TIPS strategy. This strategy may provide the inflation protection that investors want without the potential duration risk of TIPS. 

 

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