In past bond bear market episodes, evidence has shown inflation-linked bonds (ILBs) outperform nominal bonds, and this is one reason why investors have added exposure over the past years. Unusually though, US Treasury Inflation-Protected Securities (TIPS) underperformed nominal Treasuries in 2013, as real interest rates moved higher.
Deeper analysis suggests this was not a total anomaly but rather a correction of past monetary policy induced excesses, with the Federal Reserve taking a harder line on its asset purchases at a time inflation was very well in check. We believe that ILB investors should not fear the end of QE, with inflation expected to bottom in late Q2 2014 and converge toward the Fed’s target.
A nominal Treasury bond’s yield can be broken down into a real interest rate (the real yield) and an inflation expectation. Regressing real bond on nominal bond yield moves helps to understand how the ILB market adapts to changes in benchmark nominal yields, a measure called the 'beta'.
A regression analysis shows that ILBs have historically been less sensitive to duration shifts than their nominal counterparts, meaning investors have rightly been using the ILB market as a way to be less exposed to future monetary policy tightening.
A beta health-check
Sudden regime changes in betas are often associated with inflation moving away from the official Fed target of 2%. This makes higher betas in 2013 more understandable as inflation was not only lower than expected but the Fed also started to discuss less accommodative monetary policy.
Should central banks tighten monetary policies while inflation isn’t perceived a risk it would be logical to have betas higher than 1 over several months as real interest rates would have to rise without stronger inflation compensating for it. Such reasoning suggests that this is what derailed the ILB market in 2013 as the investment community was afraid of early tightening in the US.
Central bankers aim to anchor inflation and inflation expectations to explicit targets, usually looking 12-36 months ahead with the long-term drivers of inflation – output gaps and inflation expectations. As long as inflation expectations from investors, consumers and economists remain anchored, inflation will remain a mean reverting process.
The Fed has swiftly eased monetary policy when inflation expectations became too low. By reviewing the Fed’s preferred measure of future inflation, we can see when it has hit standard deviations below its long term average, the Fed has introduced unconventional policy measures.
In this environment it is no surprise that ILB outperformance to nominal treasuries is highly correlated to the trend in inflation itself. Strong TIPS performance in Q1 2013 should also been seen as an anomaly that was probably corrected in the selloff between May and July 2013.
2013 correlation purged past TIPS excesses
While 2013 correlations between inflation linked and nominal bonds isn’t 'normal' and probably shows some stress, we believe that the 2013 episode has purged past excesses in the TIPS market.
Over the next few years we expect ILB performance relative to nominal bonds to remain driven by inflation itself, as central bankers repeat their commitments to inflation targets.
There have been supportive flows in US TIPS suggesting attractive valuations, and we expect this market to deliver the most, with inflation contained for the next quarter before rising again in Q2 2014.
For UK linkers, 5-10Y negative real yields are too big a risk, while in the euro area, although the ECB has been downplaying deflation risk, it appears clear the institution will act again.
We believe that inflation will soon start to surprise to the upside in countries where currencies have depreciated. In a rising rates environment, growth is likely to generate more inflation and yield enhancement is key for investors who can afford being flexible and selective in their allocation.
Jonathan Baltora is manager of Axa World Funds Universal Inflation Bonds.
