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Derivatives

A Primer On Using The Inflation Market

Investors rarely hedge against inflation, thinking the days of hyperinflation are long gone. But inflation can still make serious inroads into an investor's profit. For example, investors buying five-year U.S. government bonds will see real returns fall from barely above 1% to zero should inflation remain at 3%, instead of returning to 1.7%, predicted by the market.

Definition Of Inflation, Caveats

Establishing a correct measure of inflation, as our central bankers have shown, is virtually impossible. The information technology sector highlights the problems. While the price of computers has remained stable, there is no way to quantify the technological, work pattern and efficiency improvements they have enabled. Governments have however attempted to measure inflation and have established several benchmarks, including CPI in the U.S. and HICP in the eurozone.

Products

Governments spearheaded the development of an inflation market by issuing index-linked bonds, the first ones issued in 1982. All of the government issued index-linked bonds offer real returns, meaning both the coupon and the principal redemption are linked to inflation, or mathematically, the coupon in year i is:

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While the redemption amount in year n is:

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Note that while the principal is typically floored at the original amount, the coupon is not.

These notes are ideally suited to investors looking to put capital to work and protect it from inflation. They do however suffer from a number of drawbacks, which can limit their usefulness for fund managers or private investors, namely:

* Low spread, the typical yield on a government bond is sub LIBOR.

* Only the funds invested are protected from inflation thus limiting the impact of the inflation protection to that portion of the portfolio.

* Small number of issuers. The few inflation-linked bonds that are not issued by governments are both illiquid and concentrated in the utilities sector.

* Payments are back-loaded. The investor's current coupons are lower than future coupons, which may cause concern for private investors. In many jurisdictions, investors are also taxed annually on principal accretion, although gains will not be paid until the bond is sold or matures.

 

Inflation In A Portfolio

Inflation bonds are of particular interest to fund managers whose mandate or regulatory environment requires them to give their investors real rates of return.

Inflation bonds should also be of interest to more traditional fund managers looking for diversification opportunities. This requires us to look at correlation of inflation with other asset classes. First from a theoretical perspective, we find that as inflation reflects the rise in prices throughout the economy and these higher prices translate into higher profits for companies, inflation should be highly correlated to the stock market. We also find that inflation should be highly correlated to front-end interest rates as central banks actively target inflation and use interest rates as their monetary policy tool. To the extent that interest rates in the longer-end of the curve respond to moves in the short-end, inflation should also be correlated to long-end rates.

But, do the facts reflect the theory? We looked at historical data given a sample portfolio. One of the over-riding concerns when choosing our portfolio was that the instruments within it must be liquid and have sufficient price history to support using regression analysis. We therefore chose the Standard & Poor's 500 for stocks, five-year U.S. Treasuries for bonds and TIPS as the inflation product.

Looking at historical regression analysis of interest rates and stock prices versus inflation, we found positive correlations of 0.65 and 0.40, respectively, to support our supposition. This also suggests value in portfolio diversification and we therefore proceeded with our analysis to look at constructing an efficient frontier. We chose an investment horizon of five years.

Given that the correlations between the asset classes are relatively high, the expected nominal return and volatility will play a key role in determining the allocation of the assets to the portfolio. For the volatility numbers of all the asset classes, we based our numbers on historical analysis over the past five years, which given market implied volatilities, is perhaps higher than we would expect going forward. However, given the long-term trends in correlation levels, volatility numbers should remain proportional to one another, hence an overall reduction on market volatility should not affect our asset allocation choices significantly.

The numbers for the expected returns were, however, more difficult to determine. A historical analysis of returns over the past five years unsurprisingly gave us results that do not represent our expectation, for example would we necessarily expect stock returns to be negative over the next five years? Probably not. Looking instead at various predictions in the market, we used an 8% expected return for equities; for Treasuries, we assumed our returns would be equal to the five-year treasury yield, 3%. For TIPS, we expect the returns to be equal to those of Treasuries given market-implied break even levels. In order to be conservative in our analysis, we assumed a break-even level below those implied by the market, we chose 1.20% instead of 1.70%. That is an assumed return of 2.50%.

Finally, we assumed there was no tax, regulatory or accounting impact of holding one asset class as opposed to another.

We have combined the whole picture in the chart below.

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The results show portfolio managers should be holding a major part of their portfolios in TIPS, suggesting that, given the low interest rates achievable in the current market conditions, inflation hedging/investing should in fact be an important part of any investment decision.

Interestingly, this efficient frontier calculation remains relatively stable even if we shift our assumptions of returns or if we stress our asset volatility numbers, as long as the following remain true:

* Equity returns >> U.S. Treasuries or TIPS returns

* Equity volatility >> U.S. Treasury volatility > TIPS volatility

Inflation Swaps

Inflation investing and hedging is facilitated by the development of an inflation swap market. Buyers of inflation tend to be pension funds required to offer real returns, either by policy or regulators, while sellers tend to be utilities, where the regulators typically link the unit price of their product to inflation. The inflation swap market comes in two forms, both of which are contracts for differences:

* Running annual coupon basis, where the coupon in each year is the difference between the inflation recorded for that year and some agreed price. For example, using HICP as the index and looking at a maturity of 10 years, then, at the time of writing, it would cost an investor 2.00% per annum to receive inflation every year.

* Zero coupon inflation swap, where, at maturity, one party pays the price compounded until maturity, while the others pays the compounded inflation over the entire period, or mathematically In/I0.

* The development of the HICP inflation swap market has led to a more efficient market, namely:

* A curve with maturity of up to 10 years allowing greater flexibility in managing a portfolio. The bond market offers only an extremely limited number of maturity points on the curve.

* Inflation swaps can be used in a portfolio to manage inflation on a macro level, meaning a portfolio manager may use it as an overlay strategy, converting some of the nominal coupons or principal in the portfolio for inflation linked payments

* The development of limited inflation options market. For example, inflation floors allow inflation investors to protect themselves against deflation.

* The swaps can be packaged to create notes, allowing investors to diversify the range of credit exposures they take when trading inflation products, reducing systematic credit and sector risk. For example, recently, the most popular notes have had the following coupon formula:

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Returning to our efficient frontier analysis, we see that we could have chosen to invest in Treasuries plus an overall portfolio swap instead of having to invest in TIPS. This should interest managers looking to earn yields above those of Treasuries by taking some credit risk.

Conclusion

In the current low interest rate, low growth and high uncertainty environment, the majority of investors will not view inflation as a large risk. We have, however, indicated inflation should be a major factor in any investment decision precisely because interest rates are low and volatility is high. A small change in inflation levels will have a disproportionate impact on real returns.

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This week's Learning Curve was written by Xavier Van Hove, structurer in the fixed income group at UBS Warburg in London.

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