Investors shuffling trades amid a sputtering reflation narrative may have overlooked a little fact: Bond managers who’ve been bullish on inflation prospects this year have been winning.
Inflation-linked U.S. Treasurys—known as TIPS—are on pace to outperform their regular counterparts for the second straight year, and some of the world’s biggest investors see scope for further gains. Vanguard Group Inc., which reaped profits on inflation-protected bonds it bought in March when the outlook was at its most dire, is looking for a re-entry point. And both BlackRock Inc. and Ardea Investment Management are wagering that the market is underestimating gains in consumer prices over the next few decades.
The triumph of TIPS is more than a little ironic, given the absence of a significant acceleration in inflation this year. Even after roaring back from an 11-year low when the pandemic shuttered the world in March, expectations for price pressures remain relatively tame. But with vaccine hopes now building, some investors see these securities as a cheap way to bet on a rejuvenated global economy. The added impetus is that this is a category of debt that typically offers outsized gains when yields are stable or falling.
“TIPS perform best in a modest growth and rising-inflation-expectations environment, which is right where we are now,” said Elaine Kan, who co-manages Loomis Sayles & Co.’s Inflation Protected Securities Fund. “And nominal yields aren’t likely to go much higher at least for the next few months, which is a positive for those investing in TIPS—who also will benefit from the inflation protection if expectations go up more.”
No Bottom
The Federal Reserve somewhat put a floor under so-called nominal yields when signaling that it doesn’t want to push policy rates below zero, and may have limited the prospects for additional gains in Treasurys. Not so with TIPS, where yields can, and do, go negative; the 10-year U.S. maturity currently yields around minus 0.93%.
To be clear, that means investors are basically paying to hold this debt on the assumption they get a windfall as inflation rebounds—not a strategy for everyone. But like nominal Treasurys, TIPS benefit from demand for havens, and the additional potential for yields to decline opens up the door to greater price appreciation.
Further adding to their appeal is the longer duration that these securities generally have compared to their nominal counterparts, meaning they tend to deliver larger price gains when rates are steady or declining as they are now. TIPS have proved a stellar bet this year, earning 9.3% compared with 8% for regular Treasurys, according to Bloomberg Barclays index data.
Still, while the bond market’s main measure of inflation expectations—dubbed the breakeven rate—has bounced back to where it was at the start of 2020 thanks to the Fed’s ultra-loose policy and massive government stimulus, doubts remain about the Fed’s ability to boost it further and achieve its 2% target for annual growth in consumer prices. The breakeven rate is the CPI level needed over life of the security for the TIPS holders’ return to roughly match that similar nominal Treasury.
‘Asymmetric Opportunity’
For Ardea Investment, it boils down to a risk-reward tradeoff. Inflation may not be about to suddenly lurch higher, but the firm sees more bang for the buck in betting on an upside surprise when the market is so skewed toward inflation staying low for a long time.
This offers what Gopi Karunakaran, co-chief investment officer at Ardea, called an “asymmetric opportunity.” The limited supply of inflation bonds also helps, he said.
“One of the biggest themes over the past decade is that we’ve been entrenched for such a long time in this world of low inflation and low inflation expectations,” Karunakaran said. “Few people are prepared for that upside surprise.”
It’s hard to blame the naysayers, given how stubbornly low inflation levels have persisted for years in the world’s largest economy. The Fed’s preferred measure of inflation has been below its target for most of the last five years.