How does the bond market price inflation risk?
It’s a simple question, but as Lysander’s Ian Marthinsen notes, there’s no simple answer
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At a simple level, bond investors are looking for compensation based on three factors: real growth in GDP, projections of inflation and a small term premium for locking in bonds for longer periods. But predicting inflation is one of the enduring inefficiencies of the bond market. Farther out along the yield curve, the interplay between overnight rates, inflation and economic growth can lead to some very complex expectations regarding premiums and uncertainty in setting bond yields.
“When calculating the inflation premium, it’s important to distinguish between backward-looking inflation and forward-looking inflation,” says Ian Marthinsen, portfolio strategist with Lysander Funds Ltd., an experienced Canadian investment fund manager. “The latest CPI print is a lagging indicator that provides information about how much prices just went up looking backwards, but it’s not necessarily much help in determining what the market thinks inflation will be going forward.”
A borrower who estimates that GDP will grow two per cent annually for the next five years should expect yields of at least two per cent as compensation. But calculating an inflation premium can be complicated.
That’s because inflation and real GDP growth tend to be interdependent. If the economy grows too hot, too quickly, inflation may shoot past expectations. That may inspire central bankers to set higher overnight rates that will cool down the economy and reduce GDP growth.
“Short-term central bank rates are partly a function of inflation,” Marthinsen says. “It can get interesting to see how longer-term yields react to what central banks are doing at the short end.”
Some investors turn to inflation protection, available through such securities as U.S. Treasury Inflation-Protected Securities (TIPS) which are indexed to the U.S. consumer price index. If $100 is invested in TIPS for a five-year term at a five per cent coupon, the principal grows each year by the rate of inflation. If inflation tracks at 10 per cent the first year, the coupon would be applied to the adjusted-principal amount of $110 resulting in a first-year payment of $5.50. At the end of the five-year term, the adjusted-principal amount would be returned to the borrower.
If inflation proves higher than projected, as measured by the Breakeven Inflation Spreads, TIPS stand a good chance of performing better than conventional bonds. Even so, inflation protection doesn’t come without risk. If inflation comes in softer than expected, TIPS are more likely to underperform conventional bonds. Under deflationary conditions, the adjusted-principal of TIPS would decline (to a floor value of par) and any TIPS sold prior to maturity still mark to market and may have to be sold at a discount.
In a world of uncertainty about future economic performance, inflation, and overnight rates Canso Investment Counsel, the portfolio manager for certain Lysander Funds, takes a bottom-up approach to finding opportunities for return.
“They don’t focus on the macroeconomic picture, and don’t manage to benchmarks,” says Marthinsen. “They tend toward corporate bonds and use proprietary risk analysis to analyze credit fundamentals and focus on finding the best opportunities where they can be properly compensated for assuming risk, including the risk that inflation may pose to the borrower.”
That investment approach tends to favour corporate bonds lower on the credit quality spectrum, which also tend to have shorter duration.
Marthinsen notes that Canso’s tendency to favour short durations are a byproduct of its bottom up investment philosophy as it evaluates credit opportunities.
“Canso looks to get the best yield-to-maturity coupon over the full course of the bond’s life and get its money back at the end,” he says. “It’s not about waiting for interest rates to move a few basis points so you can sell — that’s not its alpha generator. Canso will be happy to extend duration if they’re compensated in extra credit spread.”
As uncertainty continues to prevail in how far central bank rates will rise, and both the trajectory and longevity of inflation, top-down investors will continue to find it challenging to negotiate macroeconomic headwinds.
“With uncertainty about central bank rates and inflation expectations, Canso is prepared for more volatility,” Marthinsen says. “But there are opportunities in chaos. Going forward, we believe this could continue to be more of an active manager’s market.”
For more information on Lysander Funds, visit: www.lysanderfunds.com
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