In this episode, Merganser’s CIO, Andy Smock, reviews the impact of inflation on fixed income portfolios. He unpacks possible reasons for what’s driving recent price increases, and why interest rates are moving in the opposite direction. We end by discussing how the team at Merganser is shifting portfolios to insulate against these possible risks.
Welcome to our podcast. My name is Jeffrey Addis. I am the president and chief operating officer of Merganser Capital Management. Before we begin, a few important regulatory disclosures. This presentation is for informational purposes only and should not be considered as an investment advice or a recommendation of any particular issuer, security, strategy or investment product. Now on to our podcast.
Hello and welcome to our podcast, A Bird’s-Eye View of the Bond Markets, where we discuss major themes and issues driving the US investment grade markets. I’m your host, Emily Crandall, and the topic of today’s episode is inflation. Inflation is no doubt something that’s been grabbing headlines and rattling markets in recent weeks. As a consumer, I’m sure you’ve noticed price increases in various pockets of the economy, whether it be at the gas station or out at your local restaurant. As bond investors, we want to know what’s driving this phenomenon and how does it impact our fixed income portfolios. Well, I’m lucky enough to be joined today by Merganser’s very own CEO and CIO Andy Smock, who will help us better understand these questions. Andy, welcome and thank you for being here today.
Thank you. Let’s talk about today, a lot of mixed signals out there.
Certainly, so let’s jump right into it. Andy, my first question will help set the stage. How are bonds impacted by the concept of inflation?
When we think about inflation, inflation is always cited as a major risk to fixed income, and it’s helpful to deconstruct why that is. Anything with a fixed income stream going into the future, on one hand it provides a lot of stability, because you know what you’re going to get. On the other hand, you have to think about the purchasing power of that fixed dollar amount into the future. Whenever you have a fixed coupon, which is dominating fixed income, that dollar value is going to erode in the future if you have inflation. Contrast that to a dividend, say for the same company. Dividends can go up and companies can increase prices of goods. They can pass that through in most cases, and that can increase the dividends so dividends could go up and it’s not as impacted by inflation. They will not increase the coupon of their debt.
That’s why purchasing power is impacted and how do fixed income investors deal with that. Well, if we believe that there’s going to be higher inflation, we’re going to demand a higher yield. With a new issue, that means that the coupon is higher, so that’s going to reset. You actually do get more coupon with a new issue. With an existing issue, the coupon is fixed, you can’t change it, so what happens is the price adjusts and it adjusts lower so that the yield of that security combination of price appreciation and coupon will equal the yield of the new issue. It’s kind of the mechanics of how we think about inflation and how it impacts bond prices. It’s also the same way that we think about higher yields generally. We can talk about this more in a little bit, but yields can go up for a variety of reasons. Inflation’s just one of them.
Economists have conflicting views on the nature of current price increases. On Monday, for example, President Biden called rising prices temporary. The Federal Reserve sides with President Biden in saying inflation is transitory. Andy, do you side with this way of thinking or do you believe inflation is persistent and here to stay?
I’ll give two different answers. One is that I don’t listen to what the politicians say at all because they’re going to say what they think the world wants to hear. I do listen very closely to what the Fed has to say, and I tend to agree that inflation is transitory, but it’s worth talking more about what that means. I think it’s thrown around too much, and it’s a word that is reflective of hundreds of thousands of price of goods and services down to one single word. The key to what the Fed Chair Powell has said is that he doesn’t think that there’s going to be an undesirable level inflation to the future. The goal of the Fed isn’t to have no inflation, it’s to have stable prices. What they want as the goal is 2%. They’ve said that over and over again.
In fact, 2% is very specific. They’re comfortable with symmetric risks on either side, a little bit lower or a little bit hotter or both fine. It’s not quite clear what undesirable means. It’s certainly, I think they want to get to 2%. They’d rather run it a little hot. Undesirable is somewhere quite a bit north of 2%. In my mind, I think of it as north of 3% and staying there. There are certain things that are not going to be transitory within that. Think of long-term trends of rising education costs and healthcare. Those prices are going up. They’re going up more than the average rate of inflation, and I don’t think they’re transitory. I think the rates may change over time, but I don’t think they’re going to come back to earth. There are others that are very clearly transitory like lumber prices and used car prices. You just can’t have used car prices more expensive than new cars for long.
There’s clear evidence and supply chains pointing to why those things exist. Those are two ends of the spectrum, things that are going to keep going up and things that have already begun coming down, like lumber. In the middle, there’s a whole slew of other things, other prices for goods and services. To me, as I look through CPI data and just the economy and day-to-day living, the vast majority of those appear to me to be based on transitory things such as demand outpacing supply. In capitalism, that doesn’t usually last for very long because supply catches up. Right now, the equilibrium isn’t quite here because supply chains are still disrupted. Chip shortages are one example, but even lack of labor to create more goods, more cereal boxes, whatever it is that you’re consuming. Those things that are going to continue to be elevated until there’s a balance in the market, and I think that’s going to take call it a year or even 18 months to come back into balance as long as the coronavirus and employment benefits and all those other factors are impacting it.
Which leads me to my next question about the relationship between inflation and interest rates. For months now, the rates markets have been signaling growth concerns with the yield on the 10-year treasury dropping from a high of 1.65% to more recently this morning, Andy shared with the team, it was 1.15%. However, inflation expectations as measured by CPI or Consumer Price Index are certainly on the rise, increasing in June at the fastest pace in 13 years. Historically, treasury yields are positively correlated with inflation. Why is that not the case today?
There’s two primary drivers of interest rates right now. One is inflation and the other is the Fed or more clearly the expectation of what inflation will be and the expectation of what the Fed will do. We know what inflation was looking backwards for the last quarter, and we also know that there are a lot of reasons why it was very high, including base effects and all the other things we talked about. When we look at interest rates, if interest rates are going up, they could be going up because inflation expectations are high and the market expects the Fed to respond to that inflation expectation by raising rates.
In that case, it’s very clear and that would follow the traditional path of higher inflation, higher rates. When that doesn’t happen, you have to think a little bit about what the market is focused mostly on. Right now I think the market is focused mostly on the economy and the Fed. Even though inflation is higher undoubtedly and uncomfortably high over a short period of time, the Fed does not feel that way. In order for the market to agree with that or feel the Fed is credible, Powell has come out and said that as he looks across the market, one, he’s humble about what he doesn’t know, which is an important thing to say. Being overconfident is a risk, but that all of the factors are telling him that most of these price pressures will abate over time.
If the Fed is credible and we believe the Fed that they’re transitory, then that would give good reason for rates to stay about the same. But that’s not what happened. Rates have actually fallen. They’ve fallen dramatically. And so there, I think markets are even a little bit more pessimistic than the Fed right now, predominantly because of the Delta variant and Covid cases are increasing. Investors are saying, “I think there’s actually going to be demand pullback.” We talked about demand and supply imbalances. Supplies, prefix, it’s trying to ramp up, but I think the market is saying there’s going to be a demand pullback now, and with Coronavirus cases going up, things are actually even worse than the Fed is admitting so we’re going to buy treasuries as a flight to safety.
The buying treasuries isn’t really saying the Fed’s going to cut rates. It’s a flight to safety. What asset do I want to own in the face of scary data? I think that’s where the confusion comes in. Clearly there is inflation in the background. I don’t think the market is particularly worried about that being persistent over long periods of time, and we can debate what that means. But the five- and 10-year treasury are commonly cited, so use those periods over five years or over 10 years. There are ways that we can divine what the market thinks inflation is going to be over those periods. But I think very clearly right now it’s simply a flight to quality move and my expectation is that the 10-year yield is going to move right back up to where it had been recently.
What is the investment team thinking in response to recent rate volatility and are you making any active shifts in the portfolios as a result of those beliefs?
Yeah, so one distinction I’ll make about how we’re dealing with it is talking a little bit about TIPS and nominal treasuries as we think about our allocation to government risk. TIPS are Treasury Inflation Protected Securities. Just as a quick primer, what happens with TIPS is that as inflation, CPI headline inflation, CPI goes up the principle amount, the PAR amount of those bonds go up as well. It actually is a very good straight through read of inflation. If your only choices are buying nominal treasuries or TIPS, then TIPS are pretty good “hedge” against inflation.
The problem is taking that hedge outside of the context of fixed income. I’ve gotten a lot of questions from clients about, “Oh, we should be buying TIPS right now.” The follow up is always, “Well, it depends what your other alternatives are.” If you believe there’s going to be high inflation and you can buy real assets or stocks or other things that can adjust their pricing over time, then that’s probably a better hedge than TIPS.
The reason is that TIPS will go up in value as inflation goes up. But as we discussed earlier, rates are also going up at that same time. If inflation becomes a problem, rates are going to go up yet TIP PAR amounts are going to go up. But because of the duration of those, the price is also going to come down. Call it a wash. Nominal treasuries will be negative. TIPS will be call it zero if we get a 100-basis point move in yields and commensurate move in CPI. Within fixed income, TIPS are a good place to go if that’s your universe. That is our universe. Then the next question we have to ask is, okay, so are TIPS of good value right now versus nominal treasuries? The short answer in my opinion is no. One way to measure that is what’s called breakevens.
If you look at the yield of a TIP and a yield of a nominal treasury, you can compute what the breakeven inflation rate is to make those two equal in value. Just because you think inflation’s going to be hot doesn’t mean you should buy TIPS. You have to think it’s going to be hotter than the market consensus that’s already priced into TIPS. So call it on the two year, call it like 2.8%. You have to think in over two years it’s going to be more than that and the level comes down over time. I just don’t. I don’t think that TIPS are particularly cheap right now and they are also a little bit less liquid than normal treasuries, not tremendously, but if they’re not cheap and you give up a little bit of liquidity, I’d rather just be in US treasuries. That’s within the government world.
As we look beyond the government world, I think the best bang for your buck because it checks a couple boxes right now are floating rate securities. Floating rate securities are cheap anyway. They look attractive even if you are agnostic about what’s going to happen with rates or inflation. But then you also get the added benefit that if interest rates do go up, floating rate securities, hearkening back to what we said earlier on why fixed rate securities are bad in inflation, floating rate goes up. If you have inflation and rising rates, floating rate securities adjust automatically and you don’t get hurt because your coupons are actually increasing one for one with front-end treasury yields. We like floating right treasuries and beyond that, the thing we really don’t like is residential mortgages. That doesn’t mean we don’t own any. There are stories out there that we like, but interest rate volatility is a bad thing for residential mortgages.
I wouldn’t necessarily tie that directly to inflation, but I would tie it to the confusing signals of inflation combined with case counts, combined with interest rate volatility, all mean that there’s a lot of opportunity for people to refinance as the 10-year treasury goes up and down. That’s bad because mortgage prices are well above PAR and that hurts you if you get that money back at PAR. Overall, I’d say that we’re keeping a close eye on TIPS. If oil prices drop a lot, if OPEC comes out with a big deal and oil prices drop, TIPS usually overreact to that and temporarily drop. That might be a good buying point. Right now, I don’t think they’re particularly cheap and they’re better places to go.
Andy, thank you for sharing your perspective. I certainly learned a lot and I’m sure our listeners will as well.
You bet. I have a feeling we’ll have to do another one of these in six months. Interest rates are moving quickly and sort of touching base on all of these factors again in nearly 2022.
This commentary contained or incorporated by reference certain forward-looking statements which are based on various assumptions, some of which are beyond our control. Opinions and estimates offered constitute our judgment and our subject to change without notice as our statements of financial market trends, which are based on current market conditions. No part of this presentation may be reproduced in any form or referred to in any other publication without the express written permission of Merganser Capital Management. For more information, please visit our website at www.merganser.com. Thank you.
A Bird's-Eye View of the Bond Market: Merganser Capital Management
A Bird’s-Eye View of the Bond Market offers real-time analysis and commentary covering the major themes and issues driving the U.S. investment grade markets. Subscribers will have the chance to hear from different members of the Merganser investment team, allowing listeners the opportunity to gain valuable perspective on corporate credit, securitized, government markets and the economy. The idea behind the creation of this podcast is simple: offer our listeners a consistent source of valuable fixed income market intelligence at the click of a button.