David Roberts

A subtle TIP – how Covid has affected inflation expectations

David Roberts

Over 2019, inflation across the G7 had been rising steadily and, by December, stood just under 2% on average, much closer to central bank targets than most people realised.

To account for that, US Treasury Inflation Protected Securities (TIPS) offered investors an inflation premium of around 1.8% per annum for the next ten years at that point. If inflation proved to be less than 1.8% on average, investors would have been better owning conventional US Treasury bonds; with inflation of 1.8% or more, you benefit by owning TIPS.

Volatility and changing inflation expectations

Then along came the Covid-19 crisis and an almost immediate impact of this was a collapse in inflation expectations. As the chart above shows, by March, investors were demanding an annual inflation premium of just 0.5% to hold TIPS as all the talk was of economic collapse and the ‘Japanification’ of Western markets.

To put this in perspective, owners of US Government issued 10-year TIPS lost around 15% compared to conventional bonds. Of course, that loss was ‘just’ mark to market and the US Federal Reserve quickly announced plans to support previously undoubted US debt. That, and signs inflation would actually rise in certain sectors, saw TIPS prices rebound quickly and by August, the premium of 1.8% had been restored. That proved positive for investors like us who were able to hold such securities.

Looking forward, does that recovery mean there is nothing more to be said for TIPS?

Switching into 30 year TIPS

We still own US TIPS although started to sell our ten-year bonds in late August. Our analysis showed that although inflation remains in the system, a quick rebound to pre-Covid levels is unlikely. With the US Fed still supporting the market, however, we were keen not to exit the position and noticed the difference in 10 and 30- year inflation expectations had moved close to zero – an unusual situation.

With the Fed moving to ‘average inflation targeting’ (which we wrote about earlier this month), we believed the chances were that inflation would be higher in the long term than would previously have been the case so switched into 30-year TIPS at a point when few wanted to hold them. So far, so good for this trade: people seem to be coming round to our way of thinking. Had we held the 10-year securities, they would have fallen in value, whereas ours are, at time of writing, modestly higher. They have returned around 2% more than those we sold, which is not huge but important nonetheless in a low-return world.

In times of crisis, many good assets are treated badly. That was the case with TIPS and the simple strategy was to close your eyes and buy. As prices recover and overall levels look closer to fair value, however, we need to be a bit more subtle. Overall, bonds have done well for a few months and many are now expensive. Pre-crisis, we had a good track record of finding this kind of small opportunity for clients and believe that can continue to be the case in what are expected to be challenging months ahead.

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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.


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Monday, October 5, 2020, 12:39 PM