The Basis is a quarterly presentation series by our Liquid Markets Group’s Multi-Asset Solutions team providing investors with insights into derivative structures and strategies, portfolio construction and other whole-of-portfolio investment topics.
In this edition, we discuss the benefits of and instruments for hedging inflation risk.
In drought, consumers often feel pressure to drop their flood insurance. Similarly, during periods of minimal or decelerating inflation, inflation hedging may not be top of mind for some investors. But what happens if the tide turns again?
Prior to the onset of the pandemic, Australia experienced decades of well-behaved inflation and around five years of below target inflation. But the recovery from COVID, supply chain disruptions and the Russian invasion of Ukraine heralded a new period of higher inflation, which remains unresolved.
For investors, higher inflation raises concerns of portfolio losses in real terms. The threat of real losses varies across assets depending on how responsive cash flows are to rising prices. For equities, the sensitivity of future cash flows to rising inflation is uncertain, creating a potential risk to future real returns at a total portfolio level, particularly for investors that have a Consumer Price Index (CPI) plus target.
Maintaining real returns in an uncertain environment is challenging at the best of times. But when you mix in the often-competing portfolio objectives of performance tests, liquidity, and the need for return diversification, it becomes even more so.
Compounding the challenge further is the absence of a single hedge that suits all inflation scenarios.
So, how can an investor protect the long-term real returns of their portfolio against inflation?
It's complex; however, one solution could be to employ a range of instruments and strategies which, when combined, can create a potential return stream for investors that may provide a degree of protection against various types of inflation.
Below we explore the main instruments used for hedging inflation risk, with a focus on traded markets - bonds, swaps and futures.
Inflation linked bonds
An inflation linked bond (ILB) is a type of fixed-income security designed to protect investors from inflation by providing a guaranteed real yield if held to maturity. The principal and interest payments of these bonds are adjusted based on CPI. This means that as inflation rises, the bond’s principal value and the interest payments increase, helping to maintain the purchasing power of the investment.
Importantly, an ILB’s price fluctuates with both interest rates and the market’s view on future rates of inflation. These two sensitivities are sometimes misunderstood and can lead to unmet expectations during periods of inflation. To be clear, while ILBs accrue inflation over time, interim returns are also heavily influenced by anticipated inflation. It is also sensitive to changes in interest rates, however, this sensitivity can be managed and reduced by hedging the interest rate risk. An ILB with an interest rate hedge provides exposure largely determined by unexpected inflation.
ILBs are traded in Australia, the US, Europe, UK, Japan, as well as some smaller markets. These markets also trade various maturities, making curve selection an additional factor to consider. As a physical investment, ILBs are fully funded, which can impact overall portfolio liquidity.
Zero coupon inflation swaps
A zero coupon inflation swap (ZCS) is a type of derivative used to hedge against inflation or speculate on inflation changes, providing exposure to unexpected rates of inflation. In a ZCS, one party agrees to pay a fixed rate on a notional amount, while the other party pays an inflation-adjusted rate. Unlike regular swaps, payments are made as a single lump sum at maturity rather than periodically, which means that the payoff depends on the inflation rate over the swap’s term. If inflation is higher than expected, the party receiving the inflation-adjusted payment benefits, and if inflation is lower, the fixed-rate payer benefits.
Unlike ILBs, ZCS are derivatives and do not need to be fully funded. This is a relative advantage in scenarios where portfolio liquidity is important. ZCS also offer inflation exposure without interest rate sensitivity. That is, they do not require a separate interest rate hedge that ILBs may require.
ZCS are available across a range of markets with varying liquidity – Australia, the US, Europe and the UK for example – and across various maturities. As with all hedging decisions, the optimal choice will depend on portfolio objectives and constraints and should be determined in close consultation with your investment manager.
Commodity derivatives
A commodity derivative is a financial instrument whose value is derived from the price of an underlying commodity, such as oil, gold, wheat or natural gas. These derivatives allow investors to speculate on price movements or hedge against potential risks without owning the physical commodity. Individual commodities or a basket of commodities can be particularly effective during periods of high inflation, making them a strong candidate when considering an inflation hedge.
As commodity derivatives typically track the underlying physical commodity, performance can vary depending on the underlying market. Like ZCS, commodity derivatives do not require full funding, giving them advantages where portfolio liquidity is scarce.
Commodity derivatives are available as swaps or futures. The main difference is that futures offer greater flexibility and control, while swaps can be more straightforward to implement. It pays to consider the various nuances to determine the best fit.
