As inflation roared past a 40-year high and becomes more of a significant topic of conversation, it is worth exploring ways to provide an inflation hedge in a portfolio as a potential increase in rates could undermine some strategies.
A common approach to inflation-hedging a portfolio involves Treasury Inflation Protected Securities (TIPS), which provide investors a return over inflation in the form of a coupon, based on a face value that changes with Consumer Price Index (CPI) levels. As with any bond, TIPS have a current market value that can be above or below the indexed value of the bond. Unlike most bonds, the discount or premium to the indexed value takes into consideration more than just duration and credit risks, but also expected inflation as this projected inflation would result in a modification to the indexed value. One major component to be aware of, the indexed value modifications does not remove duration risk from TIPs. For TIPs, there are times when duration plays more of a role and other times when inflation is a greater factor. Typically, unexpected high inflation or underwhelming low inflation prints drive periods when TIPS market prices are most influenced by inflation, whereas duration impact is exhibited more broadly throughout time.
To see this phenomenon in practice, at the end of 2020 the 1 year Consumer Price Index rose 1.36%* while the Bloomberg TIPS index had a total return of 10.37%*! As we know, the year 2020 was significantly impacted by COVID and emergency Fed policies bringing overnight rates rapidly down to 0%. The duration effect on bonds, including TIPS, benefitted investors significantly in the form of higher bond values as rates came crashing down. Another example can be found in 2012, when the treasury curve continued to flatten with long rates coming down while short-term rates remained at already historically low levels. In 2012 the TIPS index returned 6% with inflation ending the year at 1.68%, again a stunning return that inflation-hedging investors certainly wouldn’t have typically expected given the levels of inflation at the time.
While falling rates have provided advantages to TIPS investors, rising rates can provide unexpected risk. The latest fed tightening cycle came in 2017 and 2018, which ended with year-end CPI prints of 2.1% and 1.9% respectively. For 2017 the TIPS index had a total return of 3.0%, a spread of only 90bps over CPI, and in 2018 a total return of -1.26% which not only failed to hedge inflation, but it happened during a period when inflation would be considered to be significant, as 2% is often cited by the Federal Reserve as a threshold to construct policies around.
Rising rates during inflationary periods generally go hand-in-hand as the tools used by the Federal Reserve to combat inflation often include monetary tightening through rate hikes. Looking back twenty years, there has only been one period of sustained CPI over 2% where rates did not rise; in 2011. Rates came down during the short inflationary cycle that year, which was the only inflationary period that the TIPS index sustained total return in excess of the consumer price index:
Figure 1: Rising Rates Tended to Coincide With Inflationary Periods
Figure 2: TIPS Struggled to Hedge Inflation in 3 Out of 4 Inflationary Periods
As the second chart above shows, while TIPS generally provided significant returns above inflation, the 1 year rolling returns during inflationary periods were lower than the 1 year CPI in 3 out of the 4 periods, as well as during unexpectedly low or deflationary periods, including the Financial Crisis in late 2008/early 2009, and 2014/early 2015. Additionally, both deflationary periods look to have occurred not long after the conclusion of an inflationary period, suggesting a risk of late timing while inflation is high.
The opportunity exists to include the long-term benefits of TIPS alongside inflation-sensitive asset classes for a more potentially robust inflation-hedge within a portfolio, while also seeking to reduce the inherent duration risks of TIPS particularly when it matters most, during periods of significant inflation. Complements to TIPs can include commodities and equities which have inflation-hedging characteristics, as historically, the prices of raw materials generally rise with inflation resulting in higher commodity prices, and equities with an overweight to inflation-sensitive sectors have the potential for strong risk-adjusted returns without an overcommitment to equity market beta.
The chart below shows the rolling 1 year return over 1 year CPI for an investment with a mix of 60% TIPS Bonds, 30% Equities with an overweight to inflation sensitive sectors, and 10% Commodities, compared to the TIPS index during the same inflationary periods isolated above:
Figure 3: 2004 to 2007 Inflationary period
Figure 4: 2011 to 2012 Inflationary period
Figure 5: 2016 to 2018 Inflationary period
Figure 6: 2021 to present Inflationary period
TIPS often provided total return less than CPI during inflationary periods, suggesting the tactical opportunity to use TIPS in a portfolio specifically for an inflation hedge may not always live up to expectations. The multi-asset approach that includes TIPS as a core of the allocation, on the other hand, exhibited more potential to hedge against inflation during periods of CPI over 2%. For the longer-term core-position use case, the multi-asset approach has a significant allocation to TIPS (60%) to serve as a ballast during periods of stagflation or lack of inflation, especially benefitting when rates fall, which has shown to be the case when the Fed intends to encourage higher inflation from lower CPI prints.
One approach to a multi-asset inflation hedge includes the IndexIQ Real Return ETF, ticker CPI. IndexIQ’s ETF CPI tracks the Bloomberg IQ Multi-Asset Inflation Index, which seeks to provide exposure to equity, fixed income and commodity assets expected to benefit directly or indirectly from increases in the prices of goods and services (eg., inflation). The index is comprised of U.S. Treasury Inflation Protected Securities (TIPS) of short-, medium-, and long-terms, U.S. large capitalization equities securities, and commodities.
*Past Performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. All data Morningstar as of 4/30/22 except Consumer Price Index and Federal Funds Rate data from St. Louis Fed at fred.stlouisfed.org.
Before considering an investment in the Fund, you should understand that you could lose money. The Fund’s investment performance, because it is a fund of funds, depends on the investment performance of the underlying ETFs in which it invests. There is no guarantee that the Fund itself, or any of the ETFs in the Fund’s portfolio, will perform exactly as its underlying index. Debt Securities Risk: In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible. Commodities Risk: Exposure to the commodities markets may subject the Fund to greater volatility than investments in traditional securities, and exposure to commodities, directly or through other securities, can cause the value of the Fund’s assets to decline or fluctuate in a rapid and unpredictable manner. Derivatives Risk: Derivatives often involve a high degree of financial risk in that a relatively small movement in the price of the underlying security or benchmark may result in a disproportionately large movement, unfavorable as well as favorable, in the price of the derivative instrument. Investments in derivatives may increase the volatility of a fund’s net asset value and may result in a loss to the fund. Credit Risk: the possibility that the bond issuer may fail to pay interest and principal in a timely manner. Inflation-Protected Security Risk: The value of inflation protected securities, including TIPS, generally will fluctuate in response to changes in “real” interest rates, generally decreasing when real interest rates rise and increasing when real interest rates fall. Large Inflation Capitalization Companies Risk: Large-capitalization companies may be less able than smaller capitalization companies to adapt to changing market conditions. Large-capitalization companies may be more mature and subject to more limited growth potential compared with smaller capitalization companies. During different market cycles, the performance of large-capitalization companies has trailed the overall performance of the broader securities markets.
Duration indicates the years it takes to receive a bond’s true cost, weighing in the present value of all future coupon and principal payments.
The Bloomberg TIPS Index is designed to measure the performance of the inflation protected public obligations of the U.S. Treasury, commonly known as “TIPS.”
The Multi-Asset Index represents a combination of: 30% Bloomberg TIPS Index, 30% Bloomberg Short Term TIPS Index, 30% Bloomberg Inflation-Sensitive Equity Index, and 10% DBIQ Diversified Commodity Index.
The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
The Federal Funds Rate, referred to as the “overnight rate,” is the annualized rate that is paid on Federal Reserve Bank balances, and is determined by the Federal Open Market Committee.
The Treasury Curve refers to the price difference between long term Treasury rates and short term Treasury rates; a smaller difference suggests a flatter curve than a larger difference in rates.
Equity Market Beta is a measurement that compares the volatility of returns of an investment against those of the broader market.
All data sourced from Morningstar as of 4/30/22 with the exception of Consumer Price Index and Federal Funds Rate data which was sourced from the St Louis Fed at fred.stlouisfed.org.
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