Governments around the world have rolled out massive stimulus measures to combat the economic effects of COVID-19. And as economies reopen, there are fears of rising consumer prices. As a result, investors, market strategists and other market participants are increasingly thinking about the impact inflation might have on their portfolios.
In this environment, how can the local inflation factor and break-even inflation help us understand how changing inflation expectations can affect portfolios?
Inflation breakevens and current environment
Inflation breakeven measures the market’s inflation outlook by calculating the difference between the yield of a nominal bond and that of an inflation-linked bond of the same maturity. As a first approximation, the 10-year inflation break-even point implies what market participants expect inflation, as measured by the consumer price index, to be over the next 10 years. .1
During the COVID-19 induced stock market crash in February and March 2020, inflation breakevens dropped dramatically, as shown in the following time series plot. For what? Probably because inflation expectations have fallen. But other factors, including differences in relative liquidity between nominal and inflation-linked bonds, may also have played a role..
10-year equilibrium inflation rate
But if the break-even points are approximations of inflation expectations, they are no longer what they were at the beginning of last spring. They have been enjoying an extended recovery since mid-April thanks to the huge pandemic-related stimulus.
The message is clear: the rise in inflation is worrying.
So, concretely, how can investors manage their inflation risk?
Before discussing this issue, we must first understand the relationship between inflation thresholds and the local inflation factor.
The local inflation factor, in its gross implementation, without residualizing to other factors, attempts to capture the market inflation outlook and thus provide a hedge against inflationary risk. The raw input of the local inflation factor is the difference in total return between an inflation-linked bond index and a Treasury index.
By construction, the local inflation factor increases when realized inflation is high relative to expectations, which can be captured by breakeven inflation. Therefore, as shown in the following chart, the gross local inflation factor has shown a 97% correlation with changes in break-even inflation over the past five years.
Correlations Between Local Inflation Factor Inputs and Break-Even Inflation
However, in practice, the factor and risk analysis tool we use in our example – Venn – residualizes the less liquid local inflation factor onto the more liquid core macro factors. Of these, three – equities, credit and commodities – also have positive correlations with changes in breakeven inflation over this period. Thus, these risk factors include a certain ability to hedge inflation.
This offers an important lesson. When applying factor analysis to an investment or portfolio, exposure to local inflation as well as key macroeconomic factors and their impact on inflation exposure are key considerations.
Venn Bond Portfolio Inflation Risk Management
So how can we manage inflation risks in a portfolio?
Using Venn, we will play the role of a fixed income portfolio manager. In this case, our allocator wants to know how well its portfolio is hedged against inflation. Their current portfolio allocation across various sectors and fixed income managers is as follows:
Initial Fixed Income Portfolio Allocation
Of the $256.5 million portfolio, 42% is allocated to a core fixed income fund, 32% to a corporate bond fund and 26% split equally between two high yield bond funds.
Using Venn factor analysis, we can measure exposures to local inflation as well as major macro factors to which the local inflation factor is residual. A simpler analysis might look at the univariate beta of the portfolios relative to the Bloomberg Barclays US 10 Year Breakeven Inflation Index, which, as mentioned above, has a 97% correlation with the inflation factor. Venn raw and non-residual locale.
Historical fixed income portfolio risk statistics
The beta presented here is a way of measuring a portfolio’s exposure to changes in the outlook for inflation. But what does this beta actually mean?
The 0.05 beta of the portfolio indicates that if breakeven inflation increases by 10 basis points (bps), the portfolio should return to 4 bps.2 This suggests that the portfolio and the evolution of inflation expectations are positively correlated.
Now suppose that, as a fixed income portfolio manager, we are concerned about a possible rise in inflation and we want to hedge the portfolio more against this risk. We are considering a Treasury Inflation-Protected Securities (TIPS) fund and want to see how this might change our factor exposures and inflation sensitivity. We are therefore testing the allocation to the TIPS fund by reducing exposure to core fixed income securities.
Updated allocation of the fixed income securities portfolio
What kind of effect has this had on the portfolio’s relationship to changing inflation expectations?
Fixed income portfolio historical risk statistics updated
The updated portfolio is more sensitive to inflation expectations, suggesting that it is better protected against rising inflation than the original portfolio.
From there, we can use the same process described above to test other potential portfolio allocations, including to inflation hedges such as gold and resource stocks, to see how they may further increase the portfolio’s sensitivity to inflation.
No one knows what path inflation will take in the future. But investors may want to consider these steps to help them better understand how well their portfolios are protected against it. And if their exposure to inflation is more than they are comfortable with, they can potentially take steps to reduce it.
1. In theory, the difference in yield between nominal bonds and inflation-linked bonds of the same maturity includes more than expected inflation. For example, it may also include an inflation risk premium. Differences in relative liquidity and short-term investor demand can also affect prices.
2. To convert from return space to change space, we multiply the beta by the duration. If we approximate the duration of bonds in the TIPS and Treasuries indices to 8, then we can say that if inflation expectations rise by 10 basis points, real yields will fall by 10 basis points, assuming that this movement n does not affect nominal returns, and TIPS’ return will be +80 bps. After multiplying by a beta of 0.05, the portfolio will increase by 4 bps.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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