Inflation is one of the most important, if not the most important, financial topic of the past year and all eyes are on inflation data and how the US Federal Reserve and other central banks are responding to it. Consumer price inflation is highly visible to everyone in an economy and impacts everything from household consumption patterns to politics to the performance of investments. Investors are generally keenly aware of inflation as a general risk to their portfolios but are often unsure of how to invest to manage specific risks associated with inflation. In our view, one of the simplest tools to manage inflation risk is under-utilized: the inflation swap.
Before we provide details on inflation swaps, let’s discuss inflation risk for institutional investors. Inflation risk is the risk that inflation moves to a significantly higher level than was previously expected and either stays there for an extended period or moves higher. To measure this properly, we look at what the market thinks inflation will be over a multi-year horizon, not what trailing 12-month inflation, for example, turned out to be. The markets are most concerned about what average annual inflation will be over the next 5, 10 or more years, and it is the change in that expectation that institutional investors should be most concerned about.
In the US, we can determine what the market thinks inflation will be using the difference between yields on US Treasury Inflation Protected Securities (TIPS) and regular US Treasuries. Simplifying a bit, TIPS provide investors with a yield plus the repayment value of the underlying bond increased in-line with inflation. However, the yield on Treasuries is generally higher than on TIPS, and the difference between the two is, roughly, the market’s expectation of future average inflation.
Out of TIPS, inflation swaps were born. Inflation swaps provide investors with a way of articulating a long-term view on inflation. To use a simplified example, if a 30-year inflation swap is trading at 2%, this means that the market thinks that inflation will average 2% from today for the next 30 years. If an investor believes that there is a better than 50/50 probability that inflation will be higher than 2% over the next 30 years, then they can use an inflation swap where they will receive the difference between whatever average inflation turns out to be over 30 years, and 2%. If they think inflation is more likely to be lower, they can do the reverse. This is the most direct way to hedge changes in future inflation and is much more direct and reliable than other, more commonly used, investments that might hedge inflation.
Commodities vs Inflation Swaps
For example, investing in precious metals and commodities is often seen by investors to provide diversification and an inflation hedge. While these investments have performed well in some past inflationary regimes, they have not done so in all of them and the degree to which they provide inflation protection is highly uncertain. They also often have zero, or even negative, expected returns. Conversely, inflation swaps hedge future inflation directly, have a highly certain contractual payoff and can be used as an overlay to investments that have positive expected returns. There really is no question as to which tool is the better hedge.
Implementing an inflation swap is relatively straightforward and is similar to implementing other types of over-the-counter derivatives. Most major investment banks are willing counterparties. Investors will need to work with a derivatives manager or have the capability to enter into derivative contracts directly.
It has been very profitable for institutional investors to ignore inflation hedging over most of the past 40 years as long-term inflation expectations declined. The current upswing in inflation may be temporary and controllable by the Fed, or it may be the start of an inflation super-cycle. Either way, there are liquid and transparent tools available to investors to take a firm view on this and to implement hedges should they need them. Portfolio diversification is nice, but a 5% allocation to gold isn’t going to do very much to protect a foundation, as an example, if long-term inflation expectations rise to 4 or 5% from 2.25%. An inflation swap overlay can.