US Yield Curve Set To Continue Underperforming
One of the questions we get most frequently when discussing inflation with clients is how we can protect a fixed income portfolio against sudden changes in inflation expectations. With 10-year US Treasuries having returned -4.5% so far in 2021, we have unsurprisingly been asked this question in nearly every meeting this year.
On the face of it, one obvious answer would be to seek protection directly against the source of risk by buying inflation-linked government bonds (which for US Treasuries would be Treasury Inflation Protected Securities, or TIPS). However, in our view the usefulness of such bonds depends on the objectives of the fixed income portfolio the investor is trying to protect. Let us explain.
In a developed country such as the US, a scenario of rising inflation expectations is usually accompanied by a bear steepening across maturities of the underlying yield curve. As economic prospects improve, demand pressures should occur at some point in the future, inflation expectations thus increase and central banks will hike rates to combat this. That is the simple version. Now if the objective of a portfolio has to do with beating government bond indices, then TIPS are a good alternative to their nominal, more famous (and importantly more liquid) cousins. If however the objective is more to do with total return, then the roughly -2% return of 10-year TIPS so far this year doesn’t look so clever.
The reason for this is that while the inflation adjustment component plays in favour of those who are long TIPS, the duration component continues to play against them, i.e. there is an imbedded correlation between USTs and TIPS. If the nominal yield curve is bear steepening, then the short end of the TIPS curve can deliver positive returns in a scenario where the inflation expectations correction outweighs the duration move; this is what has actually happened this year. But in general there is no guarantee that the total return on TIPS will be positive; they should merely exhibit a relatively positive return compared to the corresponding Treasury note.
It is important to underline as well that the adjustment in inflation expectations we are going through at the moment has been the second most drastic in 20 years (second only to the aftermath of the collapse of Lehman Brothers). In other words, the current scenario would appear very favourable for TIPS vs. nominal USTs, and still total returns are negative at most points on the curve.
So back to our original question – how can bond investors protect themselves?
When inflation expectations rise because economic growth is picking up, this usually occurs alongside an improvement in company results. Combine this with a well-capitalised banking sector that ensures the doors remain wide open for refinancing debt, and the result should be default rates that remain under control as most companies and individuals are able to roll their debts. This typically makes spread products that are not exceedingly long, and with enough spread to protect against rising underlying yield curves, a good place to be. It is therefore no surprise that year-to-date, the USD, EUR and GBP high yield indices are up 0.5%, 1.1% and 1.4% respectively.
In conclusion, while TIPS remain a valid tool for fighting inflation in a fixed income portfolio, we believe there are better alternatives for investors with a more flexible mandate. If your outlook for 10-year Treasuries is negative, then their correlation to 10-year TIPS make the latter look fairly unattractive.