Wednesday, March 28, 2018

Inflation Protection Trade - TIPS Are Not Enough

Inflation is rising and is likely to be centered around 2% in the current environment. This market view may be a good null hypothesis for what many investors believe they will face in the coming year. Consequently, investors have shown renewed interest in TIPS (Treasury inflation protected securities), but we have concerns that TIPS may not provide enough return to help many pensions. Alternative investments that have  return advantages should be carefully reviewed. There are some simple disadvantages with TIPS.

First, many pensions have discount rates that are still around 7 percent, so a CPI-linked investment is not going to help gain ground versus the expected discount rate. Pension funding gaps only grow if portfolio returns are less than the discount rate. Pensions may be concerned about inflation, but on a relative basis, the matching or exceeding the discount rate is a more critical problem.

Second, the inflation that is faced by pensioners is higher than what is being stated in the CPI. The CPI-E (experimental CPI weighted for seniors) is increasing at a slightly higher rate given the mix in their consumption basket. TIPS may offer inflation protection but not for the inflation that is being faced by pensioners. 

Third, many state pension funds have COLA provisions that are often set at a rate that is higher than the CPI. In the case of many states, it could be at 3%. Hence, if there is not a TIPS premium, a TIPS return will underperform the COLA provision if COLA is higher than CPI. Additionally, any TIPS premium is present to deal with the risk with the TIPS and not as a means of supporting higher COLAs.

Unfortunately, the use of long-only commodity indices has not helped pensions because these indices have been in an extended drawdown since the financial crisis. Using commodities has not helped pensions but actually caused a performance drag.

The solution to inflation protection is to think outside the immediate inflation securities box. Three alternatives come to mind, real estate, systematic trading, and commodity risk premium portfolios. Each offers a slightly different approach to providing inflation protection. 

Real estate is a classic inflation hedge, but there are issues of liquidity and current valuations at this point in the business cycle. Leases should increase with inflation but investors will lock-in funds with limited flexibility. 

Systematic investment strategies that could include risk parity that explicitly has commodity exposure or managed futures that actively trade commodities is another alternative. Investors will have significant liquidity. There also are implicit adjustments across asset classes through active management. Dynamic asset class adjustments could provide inflation protection as allocations are changed during an inflation shock.

A relatively new strategy would be to invest in a commodity portfolio that is based on commodity risk premiums. Instead of investing in a long-only basket with fixed commodity weights, investors would build a commodity portfolio based on well-defined risk premiums such as carry (backwardation/contango), momentum (trend), value, and volatility. This portfolio will be uncorrelated with core traditional assets and should be positioned to take advantage of inflation increases.

Thinking outside the TIPS box may allow pensions to have inflation protection but also receive a return that will not be a drag relative to the expected discount factor. This is a win in almost any environment.

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