Governments all over the world have launched massive stimulus programs to combat the economic fallout from COVID-19. And as economies reopen, fears of rising consumer prices loom large. As a result, investors, market strategists and other market participants are increasingly excited about the impact inflation could have on their portfolios.
With this in mind, how can the local inflation factor and breakeven inflation help us understand how changing inflation expectations might affect portfolios?
Inflation breakeven and the present environment
The inflation breakeven rate measures the market’s inflation outlook by calculating the difference between the yield on a nominal bond and that on an inflation-indexed bond with the identical maturity. As a primary approximation, the 10-year breakeven inflation rate implies market participants’ inflation expectations, measured by the buyer price index, for the subsequent 10 years.1
During the COVID-19-induced market crash in February and March 2020, inflation breakevens fell dramatically, because the time series chart below shows. Why? Probably because inflation expectations fell. But other aspects, including relative liquidity differences between nominal and inflation-indexed bonds, can also have played a job..
10-year breakeven inflation rate
But if breakeven values ​​function an indicator of inflation expectations, they are not any longer what they were in the beginning of last spring. Thanks to the large pandemic-related economic stimulus, they’ve been on a sustained upward trend since mid-April.
The message is evident: rising inflation is a cause for concern.
So how can investors practically manage their inflation risk?
Before we answer this query, we must first understand the connection between inflation breakeven and the local inflation factor.
The Local Inflation factor, in its raw form without residualization to other aspects, attempts to capture the market’s inflation forecast and thus provide a hedge against inflation risk. The raw value of the Local Inflation factor is the difference in total return between an inflation-indexed bond index and a Treasury index.
The local inflation factor, by design, rises when actual inflation is high relative to expectations, which may be captured by breakeven inflation. As the chart below shows, the raw local inflation factor has shown a 97 percent correlation with fluctuations in breakeven inflation over the past five years.
Correlations between local inflation factor inputs and breakeven inflation
Period: January 13, 2016 to January 12, 2021, using five-day rolling returns.
In practice, nonetheless, the factor and risk evaluation tool we use in our example – Venn – resides the less liquid local inflation factor among the many more liquid core macro aspects. Of these, three – equities, credit and commodities – even have positive correlations with breakeven inflation changes over this era. So these risk aspects have some inflation hedging ability.
There is a vital lesson to be learned from this. When applying factor evaluation to an investment or portfolio, exposure to local inflation in addition to key macro aspects and their impact on inflation risk are critical considerations.
Managing inflation risk of fixed income portfolios within the Venn model
So how can we manage inflation risk in a portfolio?
Using Venn, we play the role of a hard and fast income portfolio manager. In this case, our allocator desires to know the way well his portfolio is hedged against inflation. His current portfolio allocation across different fixed income sectors and managers looks like this:
Initial allocation of the fixed-income portfolio
Of the $256.5 million portfolio, 42% is allocated to a core fixed income fund, 32% to a company bond fund and 26% is split equally between two high yield bond funds.
Using Venn factor evaluation, we will measure the exposure to local inflation in addition to the important thing macro aspects against which the local inflation factor is residualized. A less complicated evaluation might take a look at the portfolio’s univariate beta to the Bloomberg Barclays US 10 Year Breakeven Inflation Index, which, as mentioned above, has a 97% correlation with Venn’s raw, unresidualized local inflation factor.
Historical risk statistics of the fixed income portfolio
Period: January 13, 2016 to January 12, 2021, using five-day rolling returns.
The beta presented here is one technique to measure a portfolio’s vulnerability to changes within the inflation outlook. But what does this beta actually mean?
The portfolio’s beta of 0.05 indicates that if breakeven inflation increases by 10 basis points (bps), the portfolio is anticipated to return 4 bps.2 This suggests that there’s a positive correlation between the portfolio and changing inflation expectations.
Now to illustrate we’re a hard and fast income portfolio manager who is worried about the opportunity of rising inflation and desires to further hedge the portfolio against this risk. We are considering a Treasury Inflation-Protected Securities (TIPS) fund and need to see how this changes our factor exposures and inflation sensitivity. So we test the allocation to the TIPS fund by reducing the exposure to core bonds.
Updated fixed income portfolio allocation
What effect did this have on the portfolio’s relationship to changing inflation forecasts?
Historical risk statistics of the updated bond portfolio
Period: January 13 to January 12, 2021, using five-day rolling returns. The Bloomberg Barclays US 10 Year Breakeven Inflation Index is the benchmark.
The updated portfolio is more sensitive to inflation expectations, suggesting that it is healthier hedged against rising inflation than the unique portfolio.
From here, we will use the identical process described above to check other potential portfolio allocations, including inflation hedges corresponding to gold and commodity stocks, to see how they’ll further increase the portfolio’s inflation sensitivity.
No one knows what path inflation will absorb the longer term, but investors should consider these steps to higher understand how well their portfolios are hedged against inflation. And if their inflation risk is higher than they’d like, they might have the opportunity to take steps to cut back it.
1. In theory, the yield difference between nominal and inflation-indexed bonds of the identical maturity includes greater than just expected inflation. It can also include, for instance, an inflation risk premium. Relative liquidity differences and short-term investor demand also can affect pricing.
2. To convert from the yield space to the yield change space, we multiply the beta by the duration. If we estimate the duration of the bonds within the TIPS and Treasuries indices to be 8, we will say that if inflation expectations increase by 10 basis points, real yields will fall by 10 basis points (assuming that this move doesn’t affect nominal yields) and the yield on TIPS will probably be +80 basis points. After multiplying by a beta of 0.05, the portfolio will increase by 4 basis points.
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Image courtesy of Gerald R. Ford Presidential Library and Museum above Wikimedia Commons
