Why rising inflation matters
Inflation has suddenly become a hot topic and a cause of concern for many investors. Although higher inflation may reflect surging economic activity, which would typically be a good thing, this may be more than offset by the negative effect of higher rates. So, it's not inflation per se that is the problem but the possible reaction from central banks. Very low-interest rates justify the price of almost every asset, from those where there is a direct link to bonds to those where the link is more complicated, like equities. The risk is that higher rates cause the current financial edifice to crack and perhaps crumble.
Why is inflation increasing?
It is not a surprise that prices are rising. This is because supply and demand factors are combining with more technical issues.
Demand is surging. This is a result of a combination of factors such as the restart from covid lockdowns, the introduction of ultra-loose and stimulative monetary policy, along with pent up retail demand from consumers who have been unable to spend in the last year. Supply bottlenecks have caused shortages as firms struggle to get production back towards full capacity. As a result, commodity prices are rising, and the cost of shipping has surged.
The other factor to bear in mind is that inflation is typically measured as an increase in prices over the last year. This time last year, the global economy was feeling the full force of the Covid lockdown. Workers were furloughed as companies cut back production. Prices slumped; Oil temporarily traded below zero. Over a two- or three-year view, there has been much less inflation.
None of this is a surprise; most market participants had anticipated a rapid recovery. What's more difficult to predict is precisely when inflationary pressures will come through and how significant the increases will be.
Are inflation-linked bonds the answer?
If growth becomes much higher than expected and feeds through to higher rates, then the prognosis for conventional bonds is undoubtedly poor. Moreover, there would be no escaping the negative effect on process aside from investing in the shortest dated bonds. So, for many, the answer is inflation-linked bonds.
Inflation-linked bonds are perhaps one of the least well-understood assets within the bond market. The primary market for these bonds is institutional investors that have long-dated, inflation-linked liabilities. The critical feature of inflation-linked bonds is that both the coupons paid and the principal at maturity will be adjusted by reference to a measure of inflation like the Retail Price Index in the UK.
In the US, the maturity value of TIPS (Treasury Inflation-Linked Securities) is adjusted upwards daily to account for changes in the US Consumer Price Index. The coupon is set as a percentage of the adjusted maturity value and will rise as prices rise.
Figure 1: Capital and coupons reflect realised inflation
For investors that buy inflation-linked bonds when they are issued and hold them to maturity without looking at how the price changes, those assets will indeed offer protection against rising inflation and provide a positive real return. However, for everyone else, the situation is more complicated. The coupons and final maturity values will be based on realised CPI. But the price of an inflation-linked bond on any day reflects two expected or implied values.
- Expected inflation
- Long-dated interest rates.
What drives the price of inflation-linked bonds?
To illustrate how the day-to-day pricing of inflation-linked bonds responds to changing expectations of the future level of inflation and interest rates, consider an example.
At the time of issue:
- The bond has a notional value of 100%
- Expected inflation is 3% per annum
- Interest rates are 3%
- The bond promises a real return of 1% over a 20-year term
Figure2 below illustrates the cash flows that are expected.
Figure 2: Annual cash flows at issue
|YEAR||CAPITAL||COUPONS||TOTAL CASH FLOW||DISCOUNT FACTOR||PRESENT VALUE|
Figure 2 shows how at issue the coupons are forecast to rise in line with expected inflation by 3% per annum. When these are discounted at the 3% interest rate, the present value of each coupon is 1%. So, the sum of the present value of the 20 annual payments is 20%. The final maturity value is expected to be 180.61%. An investor that buys the bond at 100% at issue will receive a coupon that has a real, inflation-adjusted value of 1% and will receive a maturity value that has the same real value as the 100% purchase price today. They effectively secure a real return of 1% per annum regardless of what inflation turns out to be. It is useful to think of this in terms of the bond having a value of 120% today.
To show how the mark to market of this bond may change, we can look at how the value of the bond today changes as rates and the expected level of inflation changes.
- If expected inflation is higher than 3%, all future coupon payments and the maturity value will be raised. If expected inflation is less than 3%, then all future coupon payments and the maturity value will be reduced. If there is no change in rates, then the value of the bond will rise and fall in line with changes in expected inflation
- If interest rates increase, the present value of future cash flows will be reduced, so the value will fall. If interest rates fall, the present value of future cash flows will be higher, so the value will increase. So, if there is no change in expected inflation, the value of the inflation-linked bond will increase and decrease in the same way as a conventional bond
In reality, there is a reasonably high level of correlation between expected inflation and interest rates (see Figure 3 below,) and so the effect of higher expected inflation is offset if rates increase as well. If both increase by the same amount, there will be no change in the value of an inflation-linked bond.
Figure 3: Correlation between expected inflation and interest rates.
The difference between inflation and rates is the "real yield," which is the most important factor in determining the value of inflation-linked bonds. Broadly, the price of inflation-linked bonds will increase when real yields fall and will rise when real yields rise. Figure 4 below shows the mark to market gain or loss that would be caused by changing inflation or rates for the bond we have used so far.
Figure 4: Mark to market p/l
Figure 4 shows that if inflation were to increase from 3% to 4% and no change in rates, there would be a profit of 23.5%. Equally, if rates were to increase from 3% to 4% with no change in expected inflation, there would be a loss of 19.5%.
Figure 5: Nominal yields, breakeven inflation and real yields
Understanding this dynamic is key to understanding the performance of these securities. Some investors have made spectacular returns from holding inflation-linked bonds. A small part of this may have come from an increase in forecast inflation, but the bulk has come from a reduction in rates and a fall in the real yield. The long duration of these instruments magnifies the impact and so causes a significant mark to market volatility.
Are inflation-linked bonds a good investment now?
To answer the question we posed earlier, we must consider the outlook for real yields, that is, the difference between inflation and rates. Figure 5 below reuses some of the charts from our recent managers' comments and illustrates how expected or "breakeven" inflation has increased. In contrast, there has been a much smaller increase in nominal yields. As a result, real yields have been heading steadily downwards and are now in negative territory for USD, EUR and GBP. Real yields are close to all-time lows.
It's this extreme position that is spooking markets. Nominal yields are in effect much lower than they have ever been with inflation at current levels. As a result, many market participants think that the Fed and other central banks will be forced to raise rates as inflation increases. Given that markets are already discounting higher inflation, an increase in nominal yields could easily increase real yields. The result would be a loss of value for inflation-linked bonds.
We would council more caution. In our view, inflation-linked bonds may be a good investment; they are more likely to offer a better return than conventional bonds. Real economic growth may continue to surprise on the upside over the next few years, but the pace of acceleration is likely to flatten out. Supply-side bottlenecks will be unblocked as latent capacity is released. Inflation looks likely to continue to trend upwards, but much of this is already discounted in the pricing of inflation-linked bonds. Growth and inflation data will be erratic as the economy restarts and the shutdown is unwound.
The Fed has committed to remaining "behind the curve" and allowing inflation to overshoot in the short-term Growth will moderate as the stimulus packages are unwound, and taxpayers start to repay the mountain of government debt through higher taxes. As a result, we think that nominal and real yields will remain negative/low.
How have the inflation-linked assets we hold performed?