In the midst of a political transition, the current U.S. administration has showed an inclination toward increased infrastructure spending and lowering the marginal tax rate. This not only strains government budgets but also fosters an environment for inflation. Besides, within a short span of three months, the Fed increased the interest rates twice by 0.25%.
As a result, fixed-income investors are on the lookout for ways to protect their investments against the forecasted inflation. Not only individual investors, but several fund managers are also concerned about a major threat to purchasing power.
In this article, we will take a closer look at various strategies that investors can employ to hedge against the compounding effects of inflation on portfolio return. Also, the article would discuss the circumstances under which inflation-protected municipal debt can be issued and benefit investors.
Read our municipal bond market glossary to familiarise with the generally accepted market concepts.
What is Inflation-Protected Debt?
Inflation-protected debt, or inflation-linked bonds, are often bought during inflationary times to hedge one’s portfolio returns and protect purchasing power. In a traditional bond transaction, the principal and coupon are fixed and determined during the issuance; inflation-protected securities are indexed with an inflation index like the Consumer Price Index (CPI). Based on this index, the principal amount is adjusted upward, in turn adjusting the coupon paid.
This can be better explained in the chart below, where we compare a traditional bond with a face value of $1000 and coupon of 4% and an inflation-protected security with a coupon of 3%. The inflation is assumed to be at 3%.
In the example above, the inflation-protected security’s principal is adjusted upward due to inflation in the market. Comparatively, in year one, the principal of a traditional security remains at $1000; due to inflation, the purchasing power of the coupon ($40) is reduced to $38.83. However, during the same year, inflation-protected security’s principal gets adjusted to compensate for the 3% inflation; this in turn prevents the coupon from deteriorating due to inflation.
It is true that during inflationary periods these securities can be used as a capital preservation tool and they can perform better than traditional bonds in terms of overall return. However, relatively low trading volume of these securities makes them hard to trade in financial markets.
Furthermore, during a deflationary environment, the principal of an inflation-protected security is adjusted downward, and your interest payments are less than they would be if inflation had occurred or remained the same.
Benefits of Inflation-Linked Debt
Treasury Inflation-Protected Securities (TIPS)
Over the years, fixed-income investors have been introduced to TIPS as a very low-risk investment vehicle to protect against inflation. Normally, TIPS are indexed to the CPI.
Despite their benefits, there have not been many deals or transactions of inflation-protected municipal debt. One of the primary reasons is that, because of the illiquid nature of this type of debt, municipal debt issuers were not able to raise enough capital. Also, low inflationary periods in the U.S. over the last few years made sure that this type of debt is not required.
However, looking forward, municipalities and underwriters are exploring various avenues to issue this form of debt obligation to raise capital. As a result, liquidity can increase. This can potentially help municipalities to reduce the issuance cost and perhaps package a better deal for municipalities looking to raise capital.
Consider a couple of actual situations that demonstrate this:
- For Massachusetts-issued, CPI-indexed, general obligation debt, the coupon entailed the floating rate CPI plus 1.77%. During this time in 2005, the U.S. economy was on the rise. The debt was sold at a premium of $110.911, saving the U.S. state 10 basis points compared to a traditional fixed rate issuance.
- A more recent example comes from the UK, where the Great London Authority issued GBP 200 million of municipal debt in the form of inflation-linked bonds to finance the extension construction of their tube system. The underwriting firms estimated that this form of financing will save the Great London Authority GBP 40 million over the life of the bonds.
Do read due diligence on muni bonds to have a better understanding of the regulatory framework. Also check out the different ways to invest in muni bonds to stay up to date with the current investment strategies.
Another way for fixed-income investors to mitigate interest rate risk during inflationary phases is to opt for CPI swaps. For these, investors trade the floating rate (i.e., based on the CPI index) for a fixed rate. In this case, the investor transfers his or her interest rate risk to another party for an exchange of cash flows from the underlying security.
Compared to CPI swaps, TIPS have longer maturity that exposes them to a relatively higher interest rate risk in an inflationary environment.
Inflation-Linked Municipal Debt
Investment and fund managers usually opine that inflation-protected strategies are a good fit in your current portfolios. For instance, Nuveen Inflation Protected Municipal Bond Fund has had an overall return of more than 3.30% since inception. This fund takes positions in derivative instruments like inflation-linked swaps, options and TIPS to mitigate the eroding effects of inflation.
In addition, given the less liquid nature of any inflation-protected securities, most investors have gravitated toward mutual funds or exchange-traded funds that hold pooled funds compared to individual securities. As a result, the investor can potentially get an exposure to a wide array of issuers and maturities, protecting investors against credit risk and interest rate risk.
Key Consideration for Investors
Investors should keep the following key points in mind:
- With rising interest rates, more muni bond issuers are likely to issue inflation-linked debt compared to traditional fixed-coupon debt. A similar scenario was witnessed in 2005-2006 when the issuance of inflation-protected securities was prevalent due to high inflation expectations.
- In a diversified investment portfolio, inflation-indexed bonds can provide a much-needed hedge to protect against purchasing power risk. In addition, compared to the value of plain vanilla bonds, the value of inflation-linked bonds is more likely to increase during high inflation times.
- Investors should also keep an eye on other types of inflation-protected securities, including CPI swaps, that tend to make sense during inflationary phases.
The Bottom Line
Historically, inflation-protected debt provided low volatility and decent returns while having a risk-reduced effect on the overall portfolio. As inflation expectations are rising, more and more municipalities are considering this avenue for their future debt issues to raise capital.
However, investors must also stay cognizant of the fact that markets for inflation-protected securities are much less liquid than traditional bonds.
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