The critical feature that makes an inflation-managed bond strategy effective is the ability to obtain direct CPI exposure through the capital-efficient vehicle of total return swaps, sidestepping the low yields and duration sensitivity of TIPS and freeing up resources to invest in a diverse set of fixed income securities that can generate positive real returns.
As inflation risk looms over today’s markets, fixed income allocations are seemingly caught between the slow bleed of negative real rates and the capital losses that will come when yields adjust higher. The search for an effective remedy remains ongoing, complicated by a lack of consensus on how to respond. A Wall Street proverb may offer some guidance:
“Hedge against a known risk; diversify against an unknown risk.”
So, which is it? In this instance, the risk of rising inflation to a fixed income portfolio is very much known. The more pertinent questions concern how investors respond: Should they hedge inflation in the near term using assets with direct links to movements in the consumer price index (CPI), even if the price of certainty is the prospect of lower returns? Or would diversifying across a broader mix of real assets with some measure of positive correlation to inflation be a better approach? And what should be done with traditional duration-sensitive fixed income strategies that are directly exposed to the risk of losing value from inflation and rising rates?
Fortunately, it is possible to engineer a solution: an inflation-managed bond strategy. By making use of capital-efficient inflation swaps in lieu of Treasury Inflation-Protected Securities (TIPS)—alongside a diversified, lower duration credit-focused portfolio—investors can transform a vulnerable bond allocation from “CPI-minus” to “CPI-plus.” This type of fixed income portfolio offers direct exposure to realized CPI inflation, higher real returns and low duration risk, along with sufficient liquidity to allow for opportunistic rebalancing down the line. As a means of defending against inflation, this approach may be superior to other public market options.
Public market real assets offer limited protection
Asset allocators looking to public markets for inflation protection have a limited set of options, none of which is particularly appealing in today’s markets. Ultimately, these standard options force investors into a choice between a costly but precise hedge strategy and a less costly hedge of uncertain effectiveness. In either case, investors are unlikely to have the latitude to allocate sufficient capital in this space to make much of a difference overall when attempting to hedge inflation.
Below, we list the most common approaches:
TIPS offer full compensation for CPI changes at maturity, but they also embed a significant amount of nominal duration exposure, which can lead to loss of capital in a rising rate environment. Furthermore, TIPS are currently offering negative real yields, making the effective cost of using them to hedge inflation risk prohibitive over anything more than a very short time horizon. For this reason, TIPS may be attractive to active fixed income managers as a tactical alternative to nominal Treasuries, but low returns and risky duration exposure should effectively disqualify them from strategic allocations going forward.
Short-term fixed income protects against capital losses from rising rates while allowing an investor to capture increases in short-term yields across time. The trade-off, of course, is receiving lower returns relative to longer-duration bonds. Active management can improve returns materially, but short-term fixed income does not typically offer returns high enough to justify a strategic allocation beyond what is needed for liquidity management. Unfortunately, the current policy environment poses challenges, as the U.S. Federal Reserve is holding short-term rates well below the level of inflation and may be “behind the curve” for some time.
Commodities can drive inflation changes and tend to correlate positively with CPI over long time horizons. Investments built around commodity futures indices, however, can experience high volatility and offer little in the way of intrinsic positive risk premia. These indices are sensitive to a host of factors, such as supply/demand imbalances and geopolitics, which have no relationship to most investors’ underlying obligations. These factors introduce a level of timing risk that may be undesirable.
Gold is often thought of as an inflation hedge, although historical evidence of this effect is decidedly mixed. Over very long time horizons, gold retains value in real terms, but over shorter horizons pricing can be disrupted by significant amounts of market noise. Furthermore, investors receive little in the way of an intrinsic positive return premium to compensate them while they wait. As with commodities, the timing risk around setting entry and exit points can dominate other factors.
Emerging market local currencies can provide a so-called first derivative relationship to commodities, given the close linkage between certain emerging market economies and commodity prices; these bonds also provide higher nominal yields than TIPS or short-term fixed income securities. However, they remain subject to a high level of idiosyncratic volatility that can diminish their effectiveness as a hedge to U.S. inflation. Few investors are willing to allocate more than a small percentage of their portfolio to this sector.
Inflation-sensitive equity sectors, such as natural resources, utilities and real estate investment trusts (REITs), have demonstrated resilient performance in inflationary periods. However, much of their risk is still related to the broader equity markets—not inflation—leaving a high degree of uncertainty about the effectiveness of these sectors as a short-term hedge. This approach does allow an inflation hedge to extend beyond the fixed income portfolio, but prioritizing allocations to particular sectors for this purpose raises a fundamental question: Do the inflation-hedging benefits outweigh the loss of exposure to the broader equity market?
As noted above, public market real assets may offer both modest returns and limited effectiveness as an inflation hedge. This quandary leaves fixed income investors searching for a response to the current environment. Left alone, bond portfolios will lose value to inflation or rising rates—and possibly both. Reducing fixed income exposure outright might be logical, but this response would only increase volatility and downside risk across the asset allocation. An inflation-managed bond strategy offers fixed income investors an escape route that can reduce these potential return drags while improving overall portfolio performance in an inflationary environment. This brings to mind another common phrase:
“Addition through the elimination of subtraction.”
Removing potential drags from structural underperformance can be just as valuable as generating higher returns elsewhere in the portfolio. Giving the fixed income portfolio the capacity to hedge CPI changes directly while minimizing or eliminating negative real yields offers just such an outcome.
Engineering a solution with the best features of TIPS, short-term credit and diversified sectors
The critical feature that makes an inflation-managed bond strategy effective is the ability to obtain direct CPI exposure through the capital-efficient vehicle of total return swaps, sidestepping the low yields and duration sensitivity of TIPS and freeing up resources to invest in a diverse set of fixed income securities that can generate positive real returns (Exhibit 1).
Within fixed income, the potential benefits of marrying higher spread and lower duration are particularly meaningful in an inflationary environment. Lower duration spread sectors, such as securitized credit and mortgage-backed securities (MBS), provide the excess return needed to generate more positive real yields. The lower duration position allows the strategy to significantly outperform traditional fixed income—or TIPS—as rates rise. Perhaps surprisingly, this reduction in duration allows an inflation-managed strategy to deliver a higher correlation to CPI across time than TIPS would have.
Engineering a solution that combines total return swaps with lower duration credit exposures links the portfolio to changes in the CPI and offers the opportunity to generate positive real yields
Exhibit 1: Key components of Treasuries, TIPS and inflation-managed bonds
An inflation swap offers the primary benefit of TIPS—direct compensation for realized inflation—without the structural disadvantages. Swap investors agree to pay a fixed rate (conceptually, the expected inflation rate) on a specific notional amount and in return receive payments equal to the actual realized inflation rate on that same notional sum. If inflation rises, the swap has a positive value; if inflation falls, the swap loses value. Additionally, a skilled investor can compare the value of TIPS with inflation swaps across the yield curve and optimize portfolio holdings of each at different points.
Keep in mind that the bond market already incorporates current inflation expectations, so an investor can usually obtain an underlying fixed income portfolio that offsets the fixed rate leg of the swap. By diversifying the portfolio to include higher yielding spread sectors, the structure should be able to outperform risk-free TIPS (Exhibit 2). Active management of the bond portfolio offers additional room for generating outperformance.
Using total return swaps in lieu of TIPS and diversifying across a range of lower duration credit securities can help transform a vulnerable bond allocation
Exhibit 2: Sector composition of a representative inflation managed bond portfolio
|Commercial mortgage-backed securities||AA-||1.79||3.73|
|Asset-backed securites (ABS)||AAA||0.52||1.23|
|Representative sample portfolio (Aggregate)||1.45||4.09|
The design and implementation of an inflation-managed strategy incorporates a broad range of fixed income instruments that deliver a tailored mix of spread sectors and overall duration. A large portion of the portfolio (60%–80%) can be allocated across MBS, asset-backed credit and corporate credit—all of which offer greater yield and resiliency to rising rates than do Treasury-backed securities like TIPS. The remainder of the portfolio can be held in short-term Treasuries for liquidity management purposes, and also in TIPS when market inefficiencies make specific securities unusually attractive. In total, the combined portfolio offers greater yield and lower duration than a pure TIPS portfolio with the same notional inflation exposure.
Inflation-proofing a fixed income allocation is no small task, but TIPS or cash may offer less inflation protection than many perceive. Investors can do better. Direct CPI exposure is available in a capital-efficient form through swaps. Diversified, low duration spread exposures can recover lost yield. Reduced duration embeds resilience in the face of rising rates. The combination demonstrates the potential for an engineered solution to give bond allocations a fighting chance in a perilous time.