Which Inflation Protection Approach Makes Sense Now? | Lord Abbett
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Market View

While Treasury inflation-protected securities (TIPS) are popular, they historically have featured higher interest-rate risk than a strategy directly tied to the Consumer Price Index.

Read time: 3 minutes

Inflation may not be on the boil in the United States, but there appears to be strong interest in finding ways to protect investment portfolios from its potential ravages. Funds that invest in Treasury inflation-protected securities (TIPS) took in a record-breaking $13.4 billion in the third quarter of 2020, according to Lipper data. The increased investor interest likely reflected the fact that inflation expectations (as measured by the five-year, five-year-forward inflation expectation rate) have risen from 0.5% to 1.82% in the past six months (as of November 3; see Figure 1) and could continue to tick higher in the near term, as the U.S. Federal Reserve (Fed) is now more willing to allow inflation to rise above 2% for some time before raising rates

 

Figure 1. Inflation Expectations Have Risen Since March 2020

Five-year, five-year-forward inflation expectation rate for the period March 19, 2020–November 3, 2020

Source: Economic Research Division, Federal Reserve Bank of St. Louis. Data as of November 3, 2020. This series is a measure of expected inflation (on average) over the five-year period that begins five years from today.

 

Fed Chairman Jerome Powell, while speaking at the central bank’s annual Jackson Hole event in August, announced the new inflation policy. As predicted, he announced the central bank would adopt a "flexible" average inflation targeting strategy. The Fed has given itself room to loosen policy (maintain low, but not negative, rates) and allow inflation to rise "moderately" above 2% for periods of time, as it focuses on increasing broad-based employment.

While there are differing views among experts about prospects for a marked increase in the price of goods and services in the United States, the Lipper fund flow data show that inflation protection remains a priority for many investors. Some investors may be looking to floating-rate notes and other hedges against inflation and rising rates, but many others are focused on TIPS. We think those interested in employing TIPS might be better off looking at funds that hedge by way of CPI swaps based on the consumer price index. Here’s why:

  1. We believe that CPI swaps offer a more efficient hedge relative to TIPS, as they don't have the real (inflation-adjusted) interest-rate exposure that exists in a TIPS portfolio. Most TIPS strategies have real interest-rate durations of approximately 5-8 years, while CPI swaps offer a purer inflation exposure—with the potential to effectively isolate portfolios from real interest-rate risk. CPI swaps historically have provided investors with strong negative correlation to interest-rate-sensitive asset classes like U.S. Treasuries (see Figure 2).

 

Figure 2. CPI Swaps Have Had Negative Correlation with U.S. Treasuries
Data for the period December 1, 2006–September 30, 2020

1Bloomberg Barclays U.S. Treasury U.S. TIPS Index. 2S&P 500 Index. 3S&P GSCI. 4Bloomberg Inflation Swap USD 5 Year Zero Coupon Index
Source: Morningstar. Data as of September 30, 2020. Data represents correlation coefficients of listed asset classes from 12/01/2006 – 09/30/2020. 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.

 

  1. CPI swaps provide a higher correlation to inflation than TIPS and the other asset classes in Figure 2, due to the direct exposure to CPI inflation. Their structure allows CPI swaps to effectively capture the difference between expected inflation and actual inflation. 

 

Figure 3. CPI Swaps Have Had Positive Correlation with Inflation
Data for the period December 1, 2006–September 30, 2020

1Bloomberg Barclays U.S. Treasury U.S. TIPS Index. 2S&P 500 Index. 3S&P GSCI. 4Bloomberg Inflation Swap USD 5 Year Zero Coupon Index.
Source: Morningstar. Data as of September 30, 2020. Data represents correlation coefficients of listed asset classes from 12/01/2006 – 09/30/2020. 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.

 

To be sure, the current low-rate environment means that even modest rates of inflation may result in negative real interest rates, as shown in Figure 4.

 

Figure 4. Tracking Real Versus Nominal Interest Rates
Real and nominal 10-year U.S. Treasury rates for the period January 2, 2003–November 3, 2020

Source: Economic Research Division, Federal Reserve Bank of St. Louis. Data as of November 3, 2020. Real interest rates are as adjusted for inflation.

 

While real rates can certainly drop lower in the near term, it is our view that they cannot be expected to stay at these low levels indefinitely. Also worth noting: An increase in real interest rates actually decreases the effectiveness of TIPS as an inflation hedge.

A Final Word

The current discussion around inflation has highlighted the need for investors to more fully investigate the various forms of inflation protection available in the market. We believe it is important for investors to understand that there are alternative approaches to purchasing TIPS to help them protect their portfolios and generate attractive returns, if inflation and interest rates begin to rise significantly in coming months.

 

A Note about Risk: The value of investments 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, and as interest rates rise, the prices of debt securities tend to fall. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes. The longer the maturity date of a security, the greater the effect a change in interest rates is likely to have on its price. U.S. Treasuries are debt obligations issued and backed by the full faith and credit of the U.S. government. Income from Treasury securities is exempt from state and local taxes. Although Treasuries are considered to have low credit risk, they are affected by other types of risk—mainly interest-rate risk (when interest rates rise, the market value of debt obligations tends to drop) and inflation risk.

TIPS (Treasury inflation-protected securities) are U.S. 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 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.

This Market View may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

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.

Correlation is a statistical measure that describes the strength of relationship between two variables. It can vary from 1.0 to -1.0.

CPI swaps are a type of interest-rate swap in which the fixed payment is based on the current, expected rate of inflation, while 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 most common type of CPI swap is a zero-coupon swap, so called because 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.

Duration is a measure of the sensitivity of the price of a fixed-income asset to a change in interest rates and is expressed in years.

The Bloomberg Barclays U.S. TIPS Index is an unmanaged index comprised of U.S. Treasury Inflation Protected Securities with at least $1 billion in outstanding face value.

The Bloomberg Inflation Swap USD 5-Year Zero Coupon Index is a tradable index designed to replicate the performance of investing in five-year inflation swaps. The index maintains a constant maturity from month to month. A zero-coupon inflation swap is an exchange of inflation-linked cash flow and a fixed cash flow at maturity. 

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

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.

The S&P GSCI (formerly the Goldman Sachs Commodity Index) serves as a benchmark for investment in the commodity markets and as a measure of commodity performance over time.

Indexes are unmanaged, do not reflect the deduction or expenses, and are not available for direct investment.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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