Bryan Dooley
Soaring inflation has upended the financial markets this year, resulting in sliding asset prices and elevated volatility. Cautious investors are bracing for unfriendly central bank policies designed to cap the steadily rising prices of goods and services.
Only six months ago, Federal Reserve Chairman Jerome Powell declared inflation “transitory” – merely a footnote in last year’s Federal Open Market Committee’s (FOMC) statements. Now, fast forward to today where the current inflation level, as measured by the consumer price index (CPI), just registered a whopping 8.6%, the highest level in 40 years!
During the low inflation era which defined most of the past two decades, investors were mainly concerned with capital preservation along with some income and growth. Now we need to be thinking about inflation protection to help offset the inevitable loss of fiat currency purchasing power in the months and perhaps years ahead.
Investors in today’s more volatile markets should be well diversified and may consider adding some non-traditional assets. Among them, Lines (TIPS) could be an important component within the fixed income portion of offshore portfolios.
While short-term bank deposits, paying less than one percent offer little in the way of financial relief, equities in strong companies are often able to pass on their higher input costs and thereby provide an attractive inflation hedge. That said, many investors lack the requisite time horizon or risk appetite to endure stock market swings.
For more conservative investors, TIPS represent another vehicle for keeping pace with rising prices. Moreover, while these securities are generally taxable onshore, offshore investors stand to gain the full benefit of increasing principal and interest if inflation continues to ravage the economy. Of course, investors should consult their tax advisors with respect to their individual situation.
TIPS are regularly issued by the U.S. government in maturities of five, 10, and 30 years. Because they are backed by the full faith and credit of the United States, these securities are considered almost risk free from a credit standpoint.
The principal value of TIPS generally rises in line with inflation and the bonds’ interest payments vary with the adjusted principal value of the securities. While TIPS coupons are fixed at the initial auction, the principal value of the bonds increases semi-annually, consistent with the headline consumer price index.
As with straight Treasury debt, prices of TIPS fluctuate in response to market interest rates and inflation expectations. Like most other bonds, longer-dated issues can be expected to experience greater volatility than shorter-dated bonds. In fact, long-term TIPS can be just as volatile as their straight Treasury counterparts over short time periods.
The notion that TIPS fluctuate with interest rate changes is an important concept, and one which is often overlooked by new investors looking into this sector. Rising inflation, for example, does not guarantee that investors will not see paper losses over short intervals, or in the event these bonds are sold prior to maturity.
For example, a five-year TIPS bond has returned -4.09% compared to a -8.09% return year-to-date on a straight five-year Treasury note. However, over the past two years, the TIPS bond achieved a total return of +7.74% compared to the -12.14% return on the regular five-year Treasury note.
While price volatility can be expected in the short run, TIPS tend to work best when they are held over longer periods and during periods of high or rising inflation. A longer holding period allows the rising principal value to catch up with CPI price increases. At the same time, coupons earned on the principal value should grow commensurate with the increasing face value of the bonds.
At maturity, TIPS return the adjusted principal or the original principal, whichever is greater. Thus, these securities also offer a built-in insurance policy against principal loss.
Importantly, the ultimate return received on a TIPS bond depends to an extent on the price and current yield at which it is purchased. In fact, economists often reference the difference between the straight Treasury yield and the comparable TIPS bond yield to calculate the ‘inflation breakeven rate’.
For example, the current five-year straight Treasury note is yielding 3.17% compared to the 0.02% yield on the five-year TIPS bonds. This means that investors are expecting an average inflation rate of 3.15% (3.17%-0.02%), over the next five years.
A risk to TIPS investors is that inflation will fall below 3.17%, making the conventional Treasury a better deal. However, if CPI inflation stays elevated above three percent, the TIPS bond should essentially earn the rate of inflation as a total investment return, thereby acting as a perfect hedge.
Bryan Dooley, CFA, is the chief investment officer at LOM Asset Management Ltd in Bermuda.
Please contact LOM at +1 345 233-0100 or visit www.lom.com for further information.
This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.
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