Hedging Inflation: A Scorecard

• Although market-implied expectations indicate modest inflation, some investors are looking for ways to hedge the possibility of longer-term inflation resulting from aggressive monetary policy and growing fiscal deficits.
• Our analysis shows that inflation hedges using U.S. Treasury inflation-protected securities (TIPS) generally underperformed other asset classes over the past 13 years.
• Our historical results are consistent with the view that investors are willing to pay a premium for inflation protection.

With almost USD 1.4 trillion outstanding, U.S. Treasury inflation-protected securities (TIPS) may be used by investors looking to construct investment strategies aimed at hedging against inflation. By taking a long position in TIPS and shorting Treasury futures, investors can create, in effect, an asset that rises in value with inflation. Comparing this asset’s historical returns to other assets’ returns may offer insight into the cost of inflation protection. Our analysis shows that this inflation asset generally underperformed other asset classes over the past 13 years.

Why Are Investors Concerned About Inflation?

Aggressive actions by central banks and soaring government budget deficits have raised concerns among some market participants that inflation may significantly rise.¹ Although market-implied measures from the U.S. Treasury market do not suggest significant increases in inflation, other potential barometers — including the price of gold — have increased greatly over the past few months.²

Investors have long memories. The raging inflation of the 1970s and early 1980s wreaked havoc on many portfolios. Fixed income was hit particularly hard, as reflected by the 750-basis-point increase in the 10-year Treasury yield between January 1973 and December 1981. Diminished economic growth contributed to generally poor inflation-adjusted equity performance. Portfolio diversification didn’t help many investors in these years, as portfolios consisting of bonds and equities performed poorly.³

Ups and Downs of Inflation and Rates

U.S. inflation is represented by the personal-consumption-expenditures price index, excluding food and energy, from the U.S. Bureau of Economic Analysis; Treasury yield is the 10-Year constant-maturity Treasury rate from the Federal Reserve Board.

What Was the Cost of Hedging Inflation?

Financial theory and empirical studies suggest that assets that perform well when the general market underperforms may have lower expected returns. Investors have viewed such assets as a form of insurance against bad economic environments.⁴ The question today is: Do investments in assets that rise in value with inflation have lower expected returns than other assets?

To help answer this question, we created a hypothetical inflation asset consisting of a long position in a TIPS index and an offsetting short position in Treasury futures.⁵ The value of this asset depends on changes in realized and market-implied inflation. This asset was designed to do well in periods of rising inflation and poorly when inflation declines.

The exhibit below shows the performance of the inflation asset versus a duration-matched portfolio of Treasury futures over the past 13 years. The value of the inflation asset was particularly volatile during 2008 and 2009, as the market grappled with the inflation implications resulting from the 2008 global financial crisis. During the COVID-19 crisis, the inflation asset initially underperformed quite significantly, but then partly rebounded as market-implied inflation expectations rose.

The Inflation Asset Has Generally Scored a Negative Return

In nine out of the past 13 years, the inflation asset had a negative return. Averaged over January 2008 and July 2020, the inflation asset had an annual return of -2.2% and significantly underperformed other major asset classes. So far during 2020, the inflation asset had a return of -2.1%.

Treasurys are represented by the iBoxx $ Treasuries Index and TIPS by iBoxx TIPS Inflation-Linked Index. The equity market is represented by the MSCI ACWI Index, U.S. investment-grade corporate bonds by the MSCI USD Investment Grade Corporate Bond Index and U.S. high-yield bonds by the MSCI USD High Yield Corporate Bond Index. Source: IHS Markit, MSCI

Was Inflation Hedging Worth It?

The 13-year period of our analysis was marked by a relatively calm and tame inflation environment. The “insurance” purchased by inflation investors may not have been needed.

The benefit from inflation protection, however, has been realized in periods of unexpectedly high inflation, and our historical results were consistent with the view that investors are willing to pay a premium for inflation protection. The experience of the 1970s and early 1980s looms large, serving as a reminder of the damage inflation can inflict on portfolios.

¹Smith, C. "US fund managers seek to safeguard portfolios against inflation." Financial Times, July 16, 2020.

²The one-year realized inflation rate (from the U.S. consumer price index ex-food and -energy) was 1.6% as of July 2020. Breakeven-inflation (BEI) yields are market-based measures of inflation expectations derived from yields on nominal Treasurys and TIPS. BEI yields are currently 1.71%, 1.72% and 1.86% for 1-year, 10-year and 30-year maturities. Gold futures have risen 31% in price since the start of the year.

³Between January 1973 and December 1981, a portfolio consisting of market-value weights of 60% equities (represented by the MSCI USA Index) and 40% 10-year Treasurys had a Sharpe ratio of -.29. Between January 1982 and July 2020, the 60/40 equity/bond portfolio had a Sharpe ratio of .75.

⁴For a discussion of expected returns, risk premia and systematic risk, see: Ang, A. Asset Management: A Systematic Approach to Factor Investing. 2014.

⁵We used five Treasury futures contracts weighted to match the effective duration profile of the iBoxx TIPS Inflation-Linked Index. The futures contracts are rebalanced monthly.

Further Reading

US inflation: The market’s implied view

A more politicized Fed? The market yawns

Did hedging tail risk pay off?

Did Bonds Deliver? Leveraging Fixed Income During the COVID Crisis