Time to get Real

A Trip Down Memory Lane?

Let’s start at the beginning – perhaps answering the age-old question: Why even bother listening to what the author has to say. To answer that properly – I will take us back in time, and across the globe...?

Inflation-linked bonds were my first sector coverage, around 20 years ago, when I was a junior portfolio manager at Lazard Asset Management in Frankfurt/Germany. Since then, I have always had a particular affinity and appreciation for the asset class. Even today, I often (half-jokingly) ask my fellow portfolio managers to offer extra critique to my ILB thoughts to ensure I am never over-valuing a long-time favorite, and leaving better ideas on the bench. ?

What I am telling you today has passed those extra steps...??

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Back to Basics?

Financial markets are extremely complex and unfortunately, it is never as easy as picking the perfect time to enter or exit markets. Anyone trying to tell you that it is – has not yet been humbled by the markets; However, what is possible is to tilt the odds in your favor.??

Without a sense of where fair value lies, it is hard to express views on directionality; how can we know where we are going, without first understanding where we stand? There are multiple ways to examine fixed income markets in order to determine a ‘fair’ yield for a risk-free government bond.??

It generally begins with the policy rate set by central banks (FED, BOE, FED, ECB, etc.), typically in response to the economic situation of the underlying country. If economic growth is vibrant and/or inflation is too high – central banks would increase the policy rate, in order to provide stability to the economy. The opposite scenario, in which economies face disinflation or recessionary risk, would result in rate cuts to provide support.?

Changes in the policy rate impact, but do not control long-term interest rates, given their reactive nature and cyclicality over time. More crucial for moderate-to-long duration bonds are expectations about inflation and future economic growth and the long-term impact that these developments will have on policy rates. Analysis of supply and demand (QE vs QT, LDI, Hedge Funds, Real Money) dynamics can overwhelm any valuation. Often however, they are a strong indicator of those critical expectations.??

While other components should not be dismissed – I aim to focus on the most dominant and critical piece of the puzzle: market expectations???

A Light in the Darkness?

For those who have come to appreciate the intricacies of ILBs, they are recognized as one of the most interesting asset classes within the fixed-income universe. ?

Most investors largely look at ILBs with a view of the relative attractiveness of “linkers” vs. their nominal counterparts. Deriving the metric commonly referred to as the break-even inflation level. This metric broadly defines the requisite level of inflation over the life of the bond to produce the same performance as nominal bonds (i.e. for the linker to break-even with nominals). While this metric is useful in terms of determining the relative attractiveness of ILBs to nominal bonds – it does not help with absolute performance considerations.??

Currently, the real yield (i.e. the yield that investors will earn prior to any inflation compensation) provides important insight beyond the ILB market and recognizes overall opportunities in fixed income. Given that inflation-linked bonds are partially a coupon-paying fixed income, part inflation (CPI) protected security: In this unique structure, investors receive two streams of compensation: a fixed coupon and a variable inflation payment. If we examine the “fixed side of the equation, we can see that the yields have spiked higher alongside the general trend in fixed income. Additionally, with positive real yields across both US and Canadian curves, investors can capture yields at levels not seen in recent years.?

The beauty of inflation-linked bonds is that investors have the “luxury” to broadly disregard the inflation expectation component - as they will receive compensation for inflation no matter the outcome. As such, there is no need to dedicate considerable time and resources to addressing inflation when considering the absolute return of ILBs. Inflation Linked Bonds provide clarity on multiple critical macroeconomic expectations and significantly improve an investor's ability to derive a strong estimate of fair value.?

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The Real Adjustment?

If inflation expectations are covered, we are left with the growth component: Let’s look at the expectations for growth.??

It is not a bold take to suggest that the growth prospects do not look overtly bullish. While different countries will experience varying levels of economic impact, globally we are facing a growing list of risks, each indicating a continuation of economic slowdown. These range from a record number of interest rate hikes, an energy crisis, de-globalization, geopolitical conflicts, etc.? Presently, the US appears to show notable resilience, and it may be longer until we start seeing the negative consequences of an unprecedented series of events over the past two years. In a previous post: ?

we argued that one should look at Canada to get a sense of where US is heading. Canada is substantially more interest rate sensitive and as such should experience negative effects earlier...?

Before one can judge if the growth expectations are more skewed to the upside or downside, we should see what the ILB market is suggesting. Real yields have increased substantially – suggesting that in recent years we have seen this growth expectation component increase substantially (or less financial repression).??

Below, we depict the past 15 years of real yields in the US:??

Here the past 15yrs of real yields in Canada:??

The sell-off in fixed-income markets has reached such a point where the real yields are at ~1.5% across all maturities. We seem to have exited the hyper accommodative post Covid-19 episode, and even surpassed the ‘secular stagnation’ phase in the aftermath of the great financial crisis. This leaves us with a scenario where the prospects of economic growth have gone down – while the real yields (the expected growth component) have moved in the opposite direction. In both cases these charts indicate that real yields have reached the highest levels since – you guessed it, the 2009 Great Financial Crisis. ?

That should at least raise some eyebrows.??

Assembling the Dream Team?

Our aim is to always tilt the expected outcomes in our favor, however despite this (hopefully relatively convincing) argument - one should not likely go all-in on inflation-linked bonds. A well-developed portfolio is not limited to a single theme or asset class, and we must consider more factors besides valuation (positioning, flows, strength of potential narratives, technical indicators, liquidity risk, etc.). However, valuation serves as a good starting point – if valuations look attractive and the time horizon is sufficiently large – it generally makes sense to look at this as an opportunity. The role of inflation-linked bonds within a portfolio may best be illustrated in sports terms (apologies – I will aim to pick other analogies in future posts).??

Let’s think about this from the perspective of a portfolio being a football/soccer team.??

• Strikers: public/private equity, pushing the ball ahead, and often the lead scorer in good times.?
• Offensive midfielders and wingers: Value stocks, High Yield bonds, providing versatility mostly on the offence?
• Midfielders: Investment Grade bonds, providing stability to the team as all-rounders?
• Defensive midfielder: Inflation Linked Bonds, providing clutch support when needed.?
• Defenders: Core government bonds, to provide much needed support when the game takes a turn for the worst.?
• Goalie: Cash, unwavering in the face of danger, but unable to put points on the board.?

Some of you likely noticed the bias here – way more fixed income than equity players. To better understand why that may be the case – Consider reviewing our prior LinkedIn and Twitter posts:

***For those that can’t find the time to take that detour: After years of being benched, in favour of equities, claiming that “There is no Alternative”, increasing yields have affirmed the belief that “There are real alternatives” and that Fixed Income is re-emerging as an attractive asset class.?

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Now let’s think how one can win the game of “Financial Football”: If a team elects to fill its ranks with “Cash” goalies, it will never let in a goal, and will never lose a single game. However, a team of goalies will also never score a goal – leading to constant draws; and nobody likes draws.??

In soccer a win is worth 3 points, a loss 0 and a draw 1 point. Constantly scoring 1 point will usually keep a team just above relegation, though without title potential, nor champions league or even top-half prospects.??

On the other hand, a team of strikers will see lots of goals – scored and conceded. It will generally do really well against weak opponents but struggle against strong ones. One’s opponent will impact how to select the team. ?Going against stronger opponents (economic downturn), most successful teams would elect to prioritize defense, while seeking to add more firepower when facing weaker teams (economic upswing). As such, only when faced with the most catastrophic and uncertain times an extremely short time horizon (last 5 min of a game to protect the win) – there is a place to fill your ranks fully in cash (11 goalkeepers). Yet for the most part, most teams would want to have players that can take control of the match and help create a meaningful chance to win the game.?

Now, how we should we consider inflation-linked bonds in this context: Our defensive midfielders.?

Usually, these players are neither the biggest nor most dominant players on the pitch, but they play a crucial role in ensuring the success of the team; Inflation-linked bonds fill that role quite well. The player has some unique skills – usually possessing a very high soccer/football IQ, with the ability to integrate into offensive play and influence the players around them. They are pushed around at times (lower liquidity/small size), but ultimately the quality and special skills of the position will prevail.??

Inflation-linked bonds have an innate sense of when it is time to attack and when it is time to prioritize defense. Inflation-linked bonds offer differentiated returns, with unique features that most teams should treasure having in their line-up. One does not have to play with that position to win the game, but most successful teams have that position occupied with a sharp and strong-minded player. ?

Playing to the adage, while offence often wins games, defense wins championships. For the past several years, defensive players were hindered in their championship efforts by their lack of contributions to the overall efforts (ultra-low yields), however the team has re-emerged with greater skill and physical ability to match. ?

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A Familiar Friend?

Beyond the fundamentals and mostly without the soccer analogies, this is how our team communicates on macro topics and trade ideas…. A glimpse into the discussions we have every day within our team.??

Not everyone shares my opinion – and I can argue against their own views, when asked to play devil’s advocate.? Thankfully, I am grateful to work with a talented team who occupies this role with passion and conviction.??

In volatile times such as these, there is seldom a “sure thing” but sometimes an old friend comes back into the picture to show why they made such a good teammate, even many years ago.?

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Congratulations on making it to the end - I hope that you found this piece insightful and informative... Hopefully, this piece helped clarify some of the developments in Fixed Income markets, enabling you, your peers, and your clients to score a few goals!?

?If you have any thoughts, comments, or questions - please let me know.?

All the best,?

Konstantin?

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This post is intended to express my personal views and should not be taken as financial advice. Please consult a financial advisor before making any investment decisions.?