By Sam Diedrich
The extraordinary liquidity provided by global central banks following the recent credit crisis has led some investors to anticipate a future rise in inflation. As investors evaluate strategies to profit from or hedge against inflation, many have considered buying inflation-linked bonds (inflation-linkers). However, in the face of a sudden rise in inflation, an inflation-indexed bond portfolio may not behave as some investors expect. Though buying inflation-linkers in lieu of nominal bonds can protect investors from principal loss due to inflation, using inflation-linkers to profit from or to hedge an overall portfolio against inflation may not be effective.
Three features in particular limit linkers’ effectiveness. First, the mechanics of the instrument limit its sensitivity to changes in realized inflation. The volatility and return of an inflation linked bond is driven by changes in real yields during the holding period, rather than by realized inflation. As a result, investors wishing to profit directly from changes in inflation are better positioned using a break-even trade structure (explored below), rather than simply buying inflation linked bonds.
Second, there may be differences between the actual economic inflation that investors face and the reference inflation represented by the index used by the bond. These differences may result in the failure of inflation linked bonds to provide adequate protection.
Finally, inflation-linkers are subject to taxation that may have a significant effect on total return. Inflation-linkers protect against inflation by adjusting principle and coupon payments for inflation. Both adjustments are taxed each year, but principle payout only happens at maturity.
Rising Inflation, Price Appreciation, and the Break-Even Position
The total return of inflation-linked bonds is driven by changes in the real yield, which, in the long run, is primarily driven by changes in real economic growth. Changes in inflation alone will not affect the price of inflation-linked bonds since increased cash flows in principle and coupon payments compensate for realized inflation (not price appreciation). For an investor who buys TIPS and holds them to maturity, the real yield the investor earns over the holding period will be the same in high inflation as in low inflation. A tactical long-only allocation to linkers in order to profit from a rise in inflation will only be effective if the rise in inflation coincides with a reduction in real yields.
Investors hoping to capture price appreciation from a change in inflation are better off constructing a “break-even” trade structure. A break-even trade structure is created by going long TIPS while shorting a duration-equivalent amount of nominal bonds against it. Crucially, this hedges out the real yield component of the nominal yield, and retains only its inflation premium component. Increases in inflation will lead to increases in nominal interest rates (price decreases in the nominal bond), and will mean profits for the short nominal bond position. The long inflation-linked position offsets any change in real yields – meaning the overall position effectively “carves out” the inflation component (premium) of the nominal yield, allowing profit purely from inflation.
An Impending Rise in Inflation May Already Be Priced In
The potential profit from a break-even or long-only linker position depends on the valuation of linkers at the time of purchase and sale. Linkers have two primary measures relevant to their valuation. The first is the break-even (BE) rate, which is essentially the difference between the yield of a nominal bond and the yield of the duration equivalent inflation-linked bond. The BE rate can be thought of as the amount of inflation needed over the holding period for an investor to be indifferent between TIPS and nominal bonds.
The second important valuation measure for TIPS is the yield to maturity, which is equivalent to the real rate of return, and is the most relevant valuation metric for long-only linker investors. These two valuation metrics indicate different market expectations depending on macroeconomic conditions. Below are scenarios where these measures change.
Typically, rising inflation rates occur during periods of economic expansion, when demand for production inputs is at its highest. This can lead to higher real rates, and thus cause TIPS to sell off. Meanwhile, the increased inflation expectations typically lead to a larger sell-off in nominal bonds that TIPS, and thus provide a profitable environment for break-even trade positions.
Conversely, an economic slowdown can lead to rising unemployment, and put downward pressure on wage inflation (demonstrated by the Phillips Curve). Capacity utilization drops, causing demand for cyclical commodities to fall. This often leads to lower levels of realized inflation and, typically, lower inflation expectations. In these scenarios, real rates are often bid quite low because investors have fewer opportunities to obtain positive real returns. This results in price appreciation for long-only allocations to TIPS. Break-even rates also decrease, as investors price in low, or even negative, rates of inflation, which means negative performance for break-even positions.
Increases in inflation also may occur due to supply-side commodity shocks. Here, break-even rates may become quite elevated due to a sudden rise in inflation expectations. Meanwhile, input price increases negatively affect economic growth, causing real rates of return priced into linkers to be bid lower. In these scenarios, break-even positions and long-only allocations to linkers can prove profitable.
During a flight to quality, investors seek the most liquid, riskless securities. Inflation expectations fall as these periods are typically coincident with dramatic reductions in economic growth expectations. Therefore, break-even rates also decrease dramatically. However, a significant portion of this fall is due to the increase in liquidity premium embedded in TIPS. Since TIPS are less liquid than Treasuries, relative demand for TIPS falls and real yields increase dramatically. In these scenarios, TIPS often sell off as real yields move higher. Meanwhile, break-even positions also post negative returns as inflation expectations collapse.
Finally, volatility in real yields can be caused by monetary action. Accommodative policy typically occurs in the context of low growth, during which the market will most likely price in very low inflation expectations. Prior to signaling policy action, break-even rates, nominal yields, and real yields are bid very low because of the low inflation expectations. However, following an announcement of accommodative policy action, nominal yields actually fall in anticipation of nominal bond purchases. With lower nominal yields and higher inflation expectations, real yields plummet. Then, as policy is implemented, inflation expectations continue rising, and nominal yields rise sharply along with break-even rates. That leads to rising real yields, and thus a sell-off in TIPS.
These scenarios illustrate how the profitability of break-even and long-only linker investments are driven by current market valuations and subsequent market movements. Depending on the break-even rate and real rate of return priced into the market at purchase, long-only and break-even positions in linkers may lose value if inflation and real rates do not move in line with market expectations. Tax Issues with Inflation-Linked Bonds
In the US, interest payments from Treasury Inflation-Protected Securities (TIPS) and inflation-related adjustments to the principal are both subject to federal tax, but exempt from state and local income taxes. The tax implications of the interest payments are straightforward: the taxable investor will owe taxes on coupon payments as paid just as with nominal bonds. As inflation rises, the taxable investor in TIPS will also accrue a tax liability on the increase in the principal value of the bonds due to the rise in inflation. However this increase in principal value is not paid to the investor until maturity of the bond. Thus the investor may have to pay taxes in the current year on cash flows they will not receive until bond maturity. Complicating the issue is the fact that the coupons on linkers are typically low, so cash inflows may be small or even less than the necessary cash outflows required to pay taxes. Inflation Index May Not Respond to Inflation Changes as Expected
The cash flows of an inflation-linked bond are protected from inflation insofar as the changes in actual ‘economic’ inflation are reflected in the reference index in an appropriate fashion. Though the inflation reference index is carefully chosen by issuers to best capture the general inflation rate in a timely manner, there are issues that can lead to differences in the inflation ratio used to compensate investors, and the ‘economic’ inflation rate seen in the economy. For example, though the CPI Index showed only a 4.5% growth over two years through 2011, commodity prices (measured by the S&P GSCI) rose much more – fully 23% over the same period.
For long-only investors who hold securities to maturity, inflation-linked bonds can serve a valuable role in a portfolio due to their embedded inflation protection. When inflation rises, inflation-linked bonds offer protection of principal and cash flows, and can outperform nominal bonds. However, for tactical investors hoping to profit from inflation, buying inflation-linked bonds may not be an effective strategy.
Inflation linkers may be limited because of their payout structure, the expected inflation already reflected in current market valuations, the determination of taxable interest, and issues with the reference inflation index. Other trade structures, including break-even structures, provide more direct means to profit from rising inflation.
Sam Diedrich is a portfolio management associate at Pacific Alternative Asset Management Company (PAAMCO), an $8.4 billion institutional fund of hedge funds.