Commentary: Inflation expectations vs. reality in the bond market

Inflation, the archnemesis of the bond market, is rattling the kettle's lid. But fixed-income investors can protect their portfolios with proper positioning and patience.

Investors have endured numerous inflationary head fakes over the past decade. In the years immediately following the global financial crisis, year-over-year consumer price index reached a peak of 3.9%. However, above-trend inflation proved temporal as countervailing shocks — the European sovereign debt crisis, the downgrade of the United States' credit rating and corrections in commodity markets — repeatedly arrested momentum. U.S. inflation remained below 3% for the remainder of the decade, averaging a sanguine 1.8% from 2010-2019.

But the '20s began with a bang. The deflationary shock of the coronavirus pandemic has been met with unprecedented monetary and fiscal stimulus. The additional quantitative easing has effectively doubled the Federal Reserve's balance sheet to more than 36% of GDP as of Feb. 28, while trillions in additional fiscal spending have expanded the federal deficit to 16.5% of GDP as of Feb. 28. The magnitude of this intervention may have yet-to-be-seen inflationary consequences, especially if our winter of economic discontent is followed by a summer of economic love in travel, dining, and leisure.

At the heart of the inflation debate is the idea that the Fed is playing a game of chicken with a rapidly expanding monetary base. So far, the savings rate has jumped, and the velocity of money has plummeted. However, 60% of CPI is tied to service-based expenses. This part of the economy has been hit hard by the pandemic but insulated from foreign wage competition. If demand-pull inflation ignites, general price levels could rise quickly, and the Fed's response would be key to rate moves.

The doves argue that the Phillips curve is broken, recent housing strength is offset by urban rent weakness and technology is supplanting labor in a variety of service-related industries. Even so, year-over-year CPI is likely to shoot toward 3% in the coming months simply due to the price trough from last spring's lockdowns. Yet, Fed Chairman Jay Powell has downplayed this rise as "small and transient" — a dovish gesture for now.

Inflation is heady macro territory. It is the nexus of many economic factors and crosscurrents. It left deep psychological wounds two generations ago. President Richard Nixon's abandonment of the gold standard in 1971 allowed volatile petrodollars to gain a chokehold on an energy-starved economy. Demand from the baby boomer generation fueled years of rapid credit expansion. Labor unions wielded powerful political influences. Those conditions proved to be the right toxic brew to unhinge aggregate prices in hindsight. But, no one had a crystal ball back then, and no one does now.

For bond investors, the fulcrum of inflation risk rests on market expectations. The availability of Treasury-inflation protected securities was not enjoyed by 1970s' bond managers. TIPS not only convey market estimates for long-term inflation, they offer a liquid insurance policy against the risk of expectations rising from here.

Currently, TIPS breakevens, or the average CPI required to match the yields on comparable maturity Treasuries, imply a 2.3% annual inflation rate during the next decade. This expectation is within the range of historical 10-year breakevens, suggesting TIPS valuations are presently fair as an inflation hedge in today's bond market.

However, TIPS yields are entrenched in negative territory. The notion of paying the federal government for protection against its inflationary policies rings ironic in today's interest rate environment. Yet, simply parking cash in money markets yielding effectively zero misses the point. Such a decision may avoid mark-to-market risk, but it invites maximum purchasing power erosion.

So, how do investors get comfortable with owning fixed income given that ultra-low interest rates risk being pushed higher by rising inflation fears? Two considerations: First, the duration of the portfolio can be managed to balance mark-to-market risk with reinvestment potential at higher yields. Second, the portfolio can be diversified with alternatives to ultra-low yielding U.S. Treasuries, such as TIPS, or other higher income-producing investment-grade alternatives such as short-duration corporate bonds.

In the third edition of "Inside the Yield Book," the authors mathematically demonstrate that the cumulative returns generated by a bond portfolio will be higher in a rising-rate environment if the investor remains invested for at least twice that of the portfolio's duration (in years). The incremental accruals earned from the portfolio's rising yield offset the mark-to-market erosion over that time frame.

For example, assume a portfolio has a 2-year duration and a 1% yield today. In Scenario 1, rates remain unchanged during the next five years, equating roughly to 1% x 5 = 5% cumulative return (ignoring compounding for simplicity). In Scenario 2, rates rise by 1% a year for the next five years, equating to 2% in mark-to-market losses each year, but accruing progressively higher income of 2% + 3% + 4% + 5% + 6% = 20%. Subtract the accrued mark-to-market losses of 10% and the cumulative return is 10% — outpacing the unchanged rate scenario by 5 percentage points. Voila! Inflation can actually benefit the patient bond investor who reinvests into higher yields.

In addition, investment-grade alternatives to U.S. Treasuries can provide additional cushioning against inflation. If the current break-even inflation expectation for 5-year TIPS is 2.5%, then 5-year corporates with 100 basis points of additional spread will increase the inflation breakeven to 3.5%. CPI has not printed above 3% in almost 10 years, so that additional yield could mean the difference between a positive and negative real return if this low-interest-rate environment persists.

Naturally, if an investor strongly believes in the current inflation narrative, then TIPS, cash and shorter durations make sense. A sharp rise in interest rates could lead to price drops even for TIPS positions. However, those who are less sure about the change in inflation expectations from here may wish to tweak their bond positioning. Short-duration, income-producing corporates and securitized holdings such as commercial mortgage-backed securities and asset-backed securities can provide a yield cushion, while generating solid cash flow that can be reinvested at higher rates. Patience, reinvestment and understanding market expectations are the keys to staying ahead of an uncertain future.

Jake Remley is a senior portfolio manager at Income Research & Management in Boston. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.