Governments around the world have deployed massive stimulus to fight the economic impacts of COVID-19. And as economies reopen, there is fear of higher consumer prices. As a result, investors, market strategists, and other market participants are increasingly considering the impact that inflation can have on their investment portfolios.
In this environment, how can factoring domestic inflation and break-even inflation help us understand how changing inflation expectations might affect portfolios?
Inflation barriers and the current environment
The inflation break-even rate measures the inflation expectations of a market by calculating the difference between the nominal bond yield and the inflation-indexed bond yield of the same maturity date. At a first approximation, the 10-year break-even inflation rate indicates what market participants expect inflation, according to the Consumer Price Index, to be over the next 10 years.1
During the market crash caused by COVID-19 in February and March 2020, inflation rates fell significantly, as the following time series chart shows. Why? Perhaps due to lower inflation expectations. But other factors, including relative differences in liquidity between nominal and inflation-indexed bonds, may have been at work as well.
10-year break-even point inflation rate
But if POS is a proxy for inflation expectations, it’s not what it was early last spring. It has been on a protracted rebound since mid-April thanks to the massive pandemic-related stimulus.
The message is clear: rising inflation is a concern.
So how practically can investors manage inflation risk?
Before addressing this question, we first need to understand the relationship between inflation stops and the domestic inflation factor.
The domestic inflation factor, in its initial implementation, with no residuals for other factors, attempts to capture market expectations of inflation and thus provide a hedge against inflation risks. The input to the crude domestic inflation factor is the total return differential between the inflation-indexed bond index and the Treasury index.
By construction, the domestic inflation factor increases when achieved inflation is high relative to expectations, which can be captured by break-even inflation. Hence, as the following chart shows, the raw domestic inflation factor showed a 97% correlation with shifts in break-even inflation over the past five years.
Correlations between domestic inflation factor inputs and break-even inflation
Time period: January 13, 2016 to January 12, 2021, using five-day rolling returns.
However, in practice, the factor and risk analysis tool we use in our example – the Venn – keeps the less liquid domestic inflation factor to the more liquid core macro factors. Of these, three – equity, credit and commodities – also have positive correlations with break-even inflation changes over the period. Thus, these risk factors have some inflation-hedging ability built into them.
This provides an important lesson. When applying factor analysis to an investment or portfolio, exposure to domestic inflation as well as underlying macro factors and how they play into inflation exposure are critical considerations.
Managing inflation risk in a fixed income portfolio
So how do we manage inflation risk across the portfolio?
Using Venn, we will play the role of fixed income portfolio manager. In this case, our allocator wants to know how well his portfolio is an inflation hedge. The distribution of their current portfolio across various fixed income segments and managers is as follows:
Initiate fixed income portfolio allocation
Of the $256.5 million portfolio, 42% is allocated to a primary fixed income fund, 32% to a corporate bond fund, and 26% is divided equally between two high-yield bond funds.
Using Venn factor analysis, we can measure exposure to domestic inflation as well as the underlying macro factors against which the domestic inflation factor is calculated. A simpler univariate empirical portfolio analysis might look at the Bloomberg Barclays 10-year Domestic Inflation Index, which, as mentioned earlier, has a 97% correlation with the crude and non-residual Venn domestic inflation factor.
Historical risk statistics for a fixed income portfolio
Time period: January 13, 2016 to January 12, 122021, using five-day rolling returns.
The beta presented here is one way to measure a portfolio’s exposure to changes in inflation expectations. But what does this beta actually mean?
The 0.05 beta of the portfolio indicates that if break-even inflation rises by 10 basis points (bps), the portfolio is expected to achieve 4 basis points.2 This indicates a positive correlation between portfolio and changing inflation expectations.
Now suppose we as a fixed-income portfolio manager, are concerned about a potential rise in inflation and want to further hedge the portfolio against this risk. We are considering the creation of a Treasury Inflation Protected Securities (TIPS) fund and want to see how this might change our exposure and inflation sensitivity. So we’re testing the allocation for the TIPS fund by reducing exposure to fixed basic income.
Updated allocation of fixed income portfolio
What kind of impact has this had on the portfolio’s relationship to shifting inflation expectations?
Historical risk statistics for fixed income portfolio updated
Time period: January 13 to January 12, 2021, using five-day rolling returns. The Bloomberg Barclays 10-Year US Inflation Index is the benchmark.
The updated portfolio is more sensitive to inflation expectations, which indicates that it is better to hedge against higher inflation than the original portfolio.
From here, we can use the same process described above to test other potential portfolio allocations, including inflation hedges such as gold and natural resource stocks, to see how they can increase portfolio inflation sensitivity.
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 investment portfolios are hedged against it. And if their exposure to inflation is more than they are comfortable with, they can take measures to reduce it.
1. In theory, the yield differential between a nominal and inflation-indexed bond of the same maturity includes more than just expected inflation. For example, it may also include an inflation risk premium. Relative liquidity differentials and short-term investor demand can also affect prices.
2. To convert from return space to give change space, we multiply beta by the duration. If we round the bond duration in the TIPS indices and Treasuries by 8, we can say that if inflation expectations rise by 10 bps, real yields will fall by 10 bps, assuming that this move does not affect nominal yields, and that the TIPS yield will be +80 bps. After multiplying by beta 0.05, the wallet will increase by 4 bps.
If you liked this post, don’t forget to subscribe Venture investor.
All posts are the opinion of the author. As such, it should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.
Image courtesy of Gerald R. Ford Presidential Library and Museum via Wikimedia Commons
Professional learning for CFA Institute members
CFA Institute members are empowered to report self-earned and self-report Professional Learning (PL) credits, including content on Venture investor. Members can easily score credits using their online PL tracker.
