Institutions with inflation-linked liabilities can choose to manage that risk in a variety of ways. Assets like equities and real estate tend to implicitly offset inflation risk over time, while inflation-linked bonds can provide a more direct exposure to realized changes in the Consumer Price Index (CPI).
The floating coupon of inflation-linked bonds may be a better tool for offsetting inflation risk for institutions such as defined benefit pension plans, whose distributions increase with the cost of living over time. While other assets may provide returns that roughly track inflation over time, inflation-linked bonds can be well suited to offset periodic, inflation-linked cash flows.
Inflation-linked government bonds can be effective at offsetting inflation risk, but the yield may not be attractive in the context of meeting portfolio level return objectives. Investing in a corporate inflation-linked bond offers both a pickup in yield from the credit spread as well as inflation protection.
Because the majority of inflation-linked debt is issued by governments, it is challenging to source enough inflation-linked corporate bonds to construct an adequately diversified portfolio. A synthetic inflation-linked corporate bond can be created by combining U.S. Treasury Inflation Protected Securities (TIPS) overlaid with a Credit Default Swap (CDS). This strategy offers both inflation protection and credit spread yield enhancement.
Treasury Inflation Protected Securities (TIPS) are US government- issued bonds that are linked to inflation. The principal of the bond is linked to the Consumer Price Index and the coupon rate is fixed, resulting in both principal and coupons that will move directly with inflation.
Credit Default Swaps (CDS) are Over the Counter (OTC) contracts that act as insurance on a bond from a single issuer. The party purchasing protection will pay a fixed periodic coupon to the other party. The CDS seller will receive periodic coupons and will be liable to pay the purchaser the principal of the bond less the recovery value in the event of a default.
Credit Default Swap Indices (CDX) are cleared derivatives comprised of a basket of 125 CDS from various issuers to form an index.
Investors can achieve a similar result by holding a physical credit portfolio in either individual bonds or an ETF and receive inflation protection via a zero-coupon inflation swap. We believe holding TIPS and selling CDS is a more attractive solution for a number of reasons. First, inflation swaps trade at persistently positive spread relative to TIPS1. This spread means that the strategy has historically had a lower overall yield compared to TIPS + CDS. Also, the market standard for inflation swaps is a zero coupon structure where both sides of the swap pay out at maturity. For this reason, this strategy may not be as effective in offsetting liability cash flows linked to inflation. TIPS also have an embedded deflation floor while inflation swaps typically do not.
Example: TIPS + Selling Credit Exposure
Combining a long TIPS position with selling credit protection results in a strategy closely resembling an inflation- linked corporate bond. As shown in the hypothetical example below, adding credit exposure to an inflation-linked government bond can bring the asset’s expected return closer to the liability growth rate.
TIPS and CDX data from Bloomberg. Compounded returns for 10 year growth comparison assume constant interest rates, constant credit spreads and realized inflation consistent with expectations.
Adding credit exposure can be achieved in either an active (single-name CDS) or passive (index CDX) manner. An active approach will involve the manager selling CDS on multiple individual bonds and allows them to express a view on sectors or individual companies. A passive approach of selling CDX gives the investor credit exposure to a basket of 125 individual Credit Default Swaps and will typically exhibit a higher level of liquidity compared to individual Credit Default Swaps. Both approaches provide fixed coupons in compensation for taking on credit risk.
Single-name CDS contracts trade Over the Counter (OTC), which requires posting collateral and introduces counterparty risk. SLC Management has extensive experience trading OTC and cleared OTC derivatives, including Credit Default Swaps. TIPS are generally accepted collateral since they are issued directly by the US Treasury and are classified as government bonds. CDX are cleared OTC, so the counterparty risk of an OTC transaction is mitigated as contracts are settled through a clearinghouse. Portfolios with cleared OTC instruments may also require an allocation to highly liquid assets to meet Initial Margin and Variation Margin requirements.
1 Source: Bloomberg
This document is intended for institutional investors only. The information in this document is not intended to provide specific financial, tax, investment, insurance, legal or accounting advice and should not be relied upon and does not constitute a specific offer to buy and/or sell securities, insurance or investment services. Investors should consult with their professional advisors before acting upon any information contained in this presentation.
SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate. Sun Life Capital Management (Canada) Inc. is a Canadian registered portfolio manager, investment fund manager, exempt market dealer and in Ontario, a commodity trading manager. Sun Life Capital Management (U.S.) LLC is registered with the U.S. Securities and Exchange Commission as an investment adviser and is also a Commodity Trading Advisor and Commodity Pool Operator registered with the Commodity Futures Trading Commission under the Commodity Exchange Act and Members of the National Futures Association.
The use of derivatives may expose the portfolio to risks that differ, and may be possibly greater than, the risks that would be generally associated with investing in fixed income assets. These risks include, but are not limited to: i) the lack of availability of a liquid market at the time that the portfolio may want to unwind a derivative contract; ii) the possibility that the portfolio may not be able to realize value from any derivatives contract if the contract counterparty cannot fulfill its obligations under the contract; and iii) the possibility that the portfolio could experience a loss of all or part of any margin, cash or securities, on deposit with that counterparty if that counterparty goes bankrupt. There is the possibility of deterioration in the functioning or liquidity of the market for derivative instruments which may decrease the value of the derivatives instruments, thereby decreasing the value of the portfolio. Under certain circumstances, the portfolio may be unable to close out derivative contracts in a timely manner or realize values that reflect the fair market values of those investments. The posting of derivative collateral and margin could result in liquidity demands for the portfolio. The portfolio will need to hold ample eligible collateral and margin to satisfy collateral requirements. Derivative contracts may include the use of leverage. Derivative collateral may not be sufficient to close out the portfolio’s obligations under its derivative contracts.
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