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Market View

Treasury inflation-protected securities may not provide the protection that investors expect.

Investors expect 2018 to be a year of faster growth for the U.S. economy, propelled by tax cuts, prospects for increased infrastructure spending, and further deregulation. In such an environment, one risk that investors may want to be mindful of is the potential for rising inflation.

To be sure, despite periodic signals that prices of goods and services may accelerate, especially in the wake of the 2016 U.S. presidential election, inflation has remained persistently low, even as the U.S. economy has strengthened. Still, as a recent Wall Street Journal report noted, some market indicators suggest inflation expectations have been climbing in recent weeks, reflecting the factors mentioned above, as well as rising energy prices. As former U.S. Federal Reserve (Fed) chair Ben Bernanke noted in a July 2007 speech, inflation expectations are an important indicator, for they “greatly influence actual inflation and thus the [Fed’s] ability to achieve price stability.”

 

Chart 1. Inflation Expectations Have Increased
Inflation expectations (%), January 18, 2011–January 18, 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.  

 

In response to these rising expectations, demand for funds that protect against inflation has increased. For the full year 2017, mutual funds in the Morningstar inflation-protected category took in $12.5 billion in flows. When combining mutual funds and exchange-traded funds (ETFs), that number increases to $19.5 billion.

In particular, higher U.S. inflation expectations have spurred demand for Treasury inflation-protected securities (TIPS), a type of U.S. Treasury bond widely used by inflation-protection funds.  (See box, “TIPS: A Closer Look.”) But while investors are attracted to the inflation-adjustment component of TIPS, they might not be interested in having exposure to another aspect of these securities: their relatively high duration.  Essentially, the benchmark 10-year TIPS is a low-yielding U.S. Treasury security, which now has an effective duration of approximately nine years. The typical TIPS mutual fund has a duration of 5.4 years, according to Morningstar data, while the typical TIPS ETF has a duration of 7.8 years..

Since they are long-duration, government-related securities, TIPS have had high correlation with U.S. Treasuries and other high-quality fixed-income securities (as represented by the Bloomberg Barclays U.S. Aggregate Bond Index). 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. For example, in 2013, a year marked by a pronounced increase in rates reflecting the U.S. bond market’s so-called “taper tantrum,” TIPS posted negative returns. As a result, the Morningstar fund category average return for the year was -7.9%, while the benchmark TIPS ETF’s return was -8.5%.  For the year, the Morningstar fund category experienced more than $27 billion in outflows.

TIPS: A Closer Look

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), more commonly referred to as the Consumer Price Index (CPI). 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, which adjusts for inflation (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.

There are alternatives for fixed-income investors who want to counter the effects of an increase in inflation on their investment returns without exposing themselves to heightened interest-rate risk. One strategy they might consider employs a portfolio of professionally managed swaps tied to the U.S. Consumer Price Index (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. (See box, “CPI Swaps: A Closer Look.”) Unlike TIPS, CPI swaps historically have a negative correlation with Treasuries (see Chart 2), which may lead to more efficient diversification for investors' fixed-income holdings. 

 

Chart 2. Strategies Employing CPI Swaps Could Add Diversification to a Fixed-Income Portfolio
Five-year correlation coefficients with indicated benchmarks, as of December 31, 2017

Source: Morningstar and Bloomberg.
CPI swaps represented by the Bloomberg Inflation Swap USD 5-Year Zero Coupon Index. TIPS (Treasury inflation-protected securities) represented by the Bloomberg Barclays U.S. TIPS Index. Bloomberg Barclays Aggregate” refers to the Bloomberg Barclays U.S. Aggregate Bond IndexU.S. Government Bonds represented by the Bloomberg Barclays U.S. Government 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, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

These qualities could make CPI swaps an important part of an alternative inflation-protection strategy. 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.

CPI Swaps: A Closer Look

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, 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.

CPI swaps come in a few varieties, the most common of which is a zero-coupon swap. These are called "zero-coupon" 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.

If the actual rate of inflation exactly matches the expected rate of inflation at the beginning of the swap agreement, the swap expires with no value.  The value of the swap will increase or decrease with changes in the actual rate of inflation.  Although a zero-coupon swap has only one form of cash flow at maturity, the swap is marked to market on a daily basis, driven by changes in inflation and inflation expectations.

For example, 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. If actual inflation exactly matches what had been expected at the initiation of the swap agreement, the CPI swap will have no impact on the returns of the underlying bond portfolio. Note, however, that in certain environments when inflation expectations are falling sharply, CPI swaps may generate negative returns. However, such periods of falling inflation expectations and interest rates are generally very positive environments for high-quality bond holdings. 

What about other traditional inflation-protection strategies, such as commodities and real estate? These approaches come with significant drawbacks that may undercut their hedging capability. For example, returns for these asset classes can be driven by idiosyncratic factors removed from the actual trajectory of inflation. CPI swaps represent more of a “pure play” on inflation—without the duration risk of TIPS.

Investors have been burned by inflation before. While there is no assurance that recent data will accurately signal a resurgence in prices, the risk remains that inflation could erode fixed-income returns. We believe hedging that risk in an effective manner is critical. By pairing a portfolio of CPI swaps with a short-term bond portfolio, investors may get the inflation protection they desire, with the potential for higher income and lower duration risk than a typical TIPS strategy.

 

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CONCERNED ABOUT INFLATION?
The Lord Abbett Inflation Focused Fund seeks to deliver total returns that exceed the rate of inflation in the U.S. over a full inflation cycle. Learn more.

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