THE BOTTOM LINE
- Inflation has a direct impact on fixed income valuations, both in the short and long run. But this all-important measure is famously difficult to measure – and could very well be lower than some may assume, and could benefit for bond investors with longer-than-benchmark duration.
- Most observers focus on the Consumer Price Index (CPI), released two weeks after the end of each month, with the June figures coming July 12. In addition to the headline figure, the release includes “core” CPI numbers, which exclude food and fuel – whose prices are more volatile than the rest of the figures.
- But under Fed Chair Janet Yellen, the favored inflation measure was derived from monthly personal consumption expenditure (PCE) figures used to calculate the country’s inflation-adjusted Gross Domestic Product (GDP). The so called PCE Deflator measures prices differently than CPI; its fans believe it to be a fairer representation of inflation as experienced by consumers.
- A third measure is imputed from prices in the bond market; it’s called the “breakeven” rate, calculated as the difference between bonds that adjust their value along with inflation and those that don’t.
- Why does all this matter? If inflation is low, bond investors can take advantage by increasing their portfolios’ sensitivity to changes in interest rates – duration – to pick up additional return
- For investors in fixed-income securities, this is critically important. If inflation is low, bond investors can take advantage by increasing their portfolios’ sensitivity to changes in interest rates – duration – to pick up additional return.
- So if inflation is lower than the market expects, longer-duration portfolios put their owners at a relative advantage. And as the chart shows, PCE inflation could very well stay below the Fed’s target for longer than the more closely-followed CPI might suggest.
- One well-established method of picking up additional yield is to increase the duration of the portfolio, since longer-dated bonds can have higher yields-to-maturity than similar issues with shorter timelines.
- That method can also increase a portfolio’s exposure to changes in interest rates.
- But – and this is key – if the risk of changes in rates is lower than the market expects, the risk incurred by increasing a portfolio’s duration could be lower as well.
- Bottom line: Active bond investors with a point of view on inflation can position portfolios accordingly, to the potential advantage of investors.
All date Source: Bloomberg, June 21 2018
The Personal Consumption Expenditures (PCE) Price Index is a measure of price changes in consumer goods and services; the measure includes data pertaining to durables, non-durables and services. This index takes consumers' changing consumption due to prices into account, whereas the Consumer Price Index uses a fixed basket of goods with weightings that do not change over time. Core PCE excludes food & energy prices.
The Consumer Price Index (CPI) measures the average change in U.S. consumer prices over time in a fixed market basket of goods and services determined by the U.S. Bureau of Labor Statistics.
The Core Consumer Price Index (Core CPI) excludes the prices of food and energy, which are volatile on a monthly basis, from the basket of goods used to determine the CPI.
An implied breakeven rate is a measure derived from comparing returns of two classes of securities whose value depends on the same factor, such as inflation or default rates.
Duration measures the sensitivity of price (the value of principal) of a fixed-income investment to a change in interest rates. The higher the duration number, the more sensitive a fixed-income investment will be to interest rate changes.