Solving the inflation equation for fixed income investors

For investors, 2021 was the year that inflation well and truly came back into the spotlight. After unleashing unprecedented monetary and fiscal stimulus on the global economy, central banks and governments now face soaring price rises, reinforced by supply chain crunches, pent-up demand and tight labour markets.

Debates around how best to hedge against these inflationary pressures can become heated. Among the oldest hedge of them all is gold, which has a strong track record over long time horizons and cannot technically default. However, over the short-to-medium-term, it can be highly volatile. 

Popular among the online crowd is Bitcoin, the controversial challenger to gold’s crown. Yet the cryptocurrency fluctuates even more wildly than its more traditional counterpart and is unproven as a long-term store of value. 

Other potential candidates, such as equities and real estate, also have some inherent long-term inflation protection. However, their ability to provide positive real returns, especially in the face of potentially higher discount rates, is far from guaranteed.  

‘To beat inflation, investors must achieve an annual return above cash. But how much do they need?’
 

Credit investments intuitively appear more vulnerable to inflationary environments. However, for investors who do not want to be exposed to the inherent volatility of other inflation hedges, history shows us that the real return required above inflation rates has not been beyond the reach of the credit risk premium that can potentially be captured by floating rate strategies.

Solving the equation: cash + X > inflation

To beat inflation, investors must achieve an annual return above cash. But how much do they need? We can express the problem using the simplest of formulas: cash + X > inflation. If we can find X, we can know how much investors have typically required.

The chart below shows the historical returns needed from cash to beat US inflation since the 1960s. Cash returns are measured using the Fed Funds rate, while inflation is represented by the US Consumer Price Index (CPI). Both are calculated using rolling three-year annualised returns.

From this chart, we can make several observations:

1. Over the long term, a return of X% above cash has mostly not been required to beat inflation.
2. When X has been required, it has been lower than many investors might have expected. During the 1970s, a period of notoriously high inflation and questionable monetary and fiscal policy, the highest return above cash needed was 1.5% p.a.
3. The highest return required was +2.4% p.a. – which was last year, as central bank policy lagged behind inflation.

It has been a similar story in Europe and the UK, which have required maximum returns of 2.6% and 2.3% above cash in local currencies respectively. Interestingly, while X was also highest in 2021 in Europe, the UK’s highest required return was in 2013. Note that we have measured since the inception of the euro currency (1999) and UK CPIH inflation measure (1989) for these comparisons.

If we equate X with the credit risk premium, which is what would be required if interest rate risks were fully hedged, this return target appears out of reach for conventional investment grade corporate and government bonds alone. However, based on current spreads, this is not beyond the realms of more flexible credit approaches that may combine these assets with alternative types of liquid credit. 

By incorporating credit investments such as asset-backed securities (ABS), loans and other, relatively liquid private debt, alongside conventional high yield and investment grade government and corporate bonds, it is possible to construct a combined portfolio with an overall investment grade credit rating that has historically been able to achieve these yields.

Returning to our other main consideration, volatility, we can see that these credit investments have historically provided much lower volatility risk than other liquid inflation hedges, namely gold and equities. In our final chart below, we can see over the past seven years, annualised volatility has been in the double digits for the latter, likely beyond the tolerance of many fixed income investors.

Given some areas of alternative credit can offer a significant spread premium above equivalently rated corporate bonds, this volatility can be reduced further in exchange for slightly lower returns, for example by increasing an allocation to AAA senior-secured European ABS, which currently offer a spread of around 70 basis points.

Have we solved the inflation equation?

Our analysis shows that cash rates may not be as poor at preserving purchasing power as many investors might think. For extended periods of time, no additional returns above cash rates have been needed to outperform inflation.

However, in periods where cash alone hasn’t been enough, the credit risk premium required has typically been achievable through more flexible multi-asset credit portfolios. 

Floating rate credit may therefore be of some interest to investors who seek a less volatile method of preserving the real value of their capital, which arguably offers us a potential solution to the inflation equation.

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.