Photograph of Steve Rodosky, Managing Director, Portfolio Manager, Real Return and U.S. Long Duration Strategies
Steve Rodosky: Many investors have been asking what's happened in the TIPS market. TIPS were unique in that even before the coronavirus there were geopolitical events that were having an adverse impact on inflation expectations and
Shot of oil pumps and shot of screen with ticker information
valuations through the oil market. Once the impact of the virus was more well understood and as societies and economies started to shut down one after the other, obviously TIPS went through this unprecedented global demand shock that was seen and felt throughout. On top of that, during the peak of the chaos there in the middle of March, there was a flight to cash on the part of investors and so TIPS, like a lot of other segments of the market, saw technical selling pressure from retail and institutional investors alike and that also impacted valuations.
If you look at inflation on a forward basis,
Chart: A single line graphs depicts the forward breakeven inflation rate from 2007 to present. The line moves from higher to lower with a marked drop at the end of the time period.
the decline seen in the first quarter was unseen going back to anywhere from crisis or pre crisis days. As low as, 1% in five year forward break even, briefly even sagging below in the middle of March.
As the economic impact of the virus spread its way deeper and deeper into financial markets, both monetary and fiscal policymakers reacted around the globe in unprecedented fashion.
Shot of Federal Reserve building
In the U.S., the Federal Reserve has bought over 100 billion worth of TIPS in the secondary market since the middle of March. And at the same time, we've seen a commitment from fiscal policymakers to provide support through spending and other initiatives in order to combat the influence of the economic seizure that has taken place.
Text on screen: What has been the impact?
Overall, at this point, the impact on the TIPS market and other sectors of financial markets has been a recognition that we have to cope with historic declines in economic activity.
Shot of airplane landing and beachfront hotels.
The hardest hit sectors airlines, hotels and the like actually passed through to inflation expectations and the pricing of inflation linked bonds relatively swiftly. And so we've seen that demand shock feed its way into the pricing of TIPS markets in earnest. Right now we also note that in reaction to this, the impact has been to take real yields lower and in some cases negative.
Chart: A line graph shows returns for the Bloomberg Barclays UK Inflation Linked Bonds TR Index and Bloomberg Barclays Eurozone Inflation Linked Bonds TR Index from 2014 to March 2020. The line starts near 6% and decreases to under 2% at the end of the period.
Remember, negative real rates have been a phenomena in Europe going back nearly six years now. And when you look at rolling three year periods of return they have always been positive over that entire time frame. This is because over and above the coupon income that is realized from owning an inflation linked bond, the investor also receives the benefit of the inflation accrual, as over the life of that bond, the impact of additional inflation is added into the principal amount of the bond held.
Text on screen: What’s Next?
Why is now a good time for investors to consider TIPS? Three reasons stand out.
Number one, against almost every way that you can value them, TIPS are quite cheap. You can look all the way out the maturity spectrum 30 years, and you see the inflation expectations are well beneath policy objectives. Number two. The technical backdrop of central bank support provides a good environment from a supply demand perspective. And number three, we see an unprecedented commitment from policymakers both monetary and fiscal, to support economic recovery out into the foreseeable future.
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Please note that the following contains the opinions of the manager as of the date noted, and may not have been updated to reflect real time market developments. All opinions are subject to change without notice.
Past performance is not a guarantee or a reliable indicator of future results.
All investments contain risk and may lose value. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government.
Breakeven inflation rate (or expectation) is a market-based measure of expected inflation or the difference between the yield of a nominal and an inflation-linked bond of the same maturity.
The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.
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