One could argue investors are spoilt for choice when it comes to looking for clues in economic and financial indicators. But some of these concepts can be difficult to understand or misunderstood. One such term that is often used by fixed income investors is the ‘breakeven’; most people, we have discovered, will think inflation breakeven when they hear that term. Did you know there was also a credit breakeven? Understanding breakevens, both the inflation and the credit breakeven could be crucial to mitigating risk.
The future of everyday bond portfolios should be considered in light of the impact of inflation, especially as interest rates remain low and inflation threatens returns. While inflation expectations differ among the central banking elite, long term investors are crystal clear on the impact that even modest uptick in inflation with have on their liabilities. The chart below shows that annualised inflation of 2.5% over 10 years erodes the performance of an investment by 22%.
We believe investors should look beyond inflation surveys or central bank expectations when it comes to investment decision-making and more specifically to the inflation breakeven.
Source: AXA IM
The inflation break even rate, which indicates what’s priced into the market in terms of inflation expectations can offer investors greater clarity on what to expect.
It is very rare that the market will offer you market pricing for economic indicators. You have proxies for GDP than can be good indicators – for instance real interest rates will move together with real GDP growth. But when it comes to inflation, the breakeven is a very ‘pure’ indicator for monetary policy and for policy making.
There are three inputs that go into calculating the inflation breakeven rate:
1. Inflation expectations. This is by far the largest component of the breakeven. However all inflation measures are not created equal. For example US CPI includes what households are buying whereas UK does not.
2. The Inflation risk premium – how much investors are willing to pay to protect their capital from erosion, thus revealing their view on inflation. When the breakeven is below the current inflation rate the premium is negative and when it is above it is positive. This is a good indication of market sentiment towards inflation.
3. The liquidity premium differential – determining the liquidity premium differential is an important indicator of how much inflation risk investors are expecting. As linkers are a government bond the liquidity premium is generally small except during periods of crisis.
The inflation breakeven is not equal to inflation expectations. It is simply the difference in the price of a nominal bond and an inflation linked bond with the same maturity.
Depending on what security you’re looking at the rate differs, and therein lies an opportunity. For example bonds at the front of the curve have a lower sensitivity to interest rates because they have shorter durations, but they also have lower break evens. This essentially makes them cheaper than longer duration, for the same level of inflation indexation. Everyone on the curve earns the same, as they are all indexed to the same rate of inflation.
A mistake many investors make is to buy inflation-linked bonds when inflation is rising, but very often it’s too late. Investors tend to look in the rear view mirror focusing on trailing inflation figures which have broadly disappointed expectations this year. But, very often times like these are the best time to buy inflation linked bonds as they are cheap, compared to times when inflation is beating expectations and as inflation is likely to rise.
We believe by taking into account measures such as the inflation breakeven and adopting a more rational approach could allow investors to buy assets when they are cheap, and not when they are ‘hot’.
The inflation breakeven should not, however, be confused with the credit breakeven.
More risk for less yield
Following the raft of central bank meetings in late October and early November, confirming interest rate rises and with rhetoric from key policymakers firmly suggesting monetary stimulus will gradually be withdrawn over the coming months, investors may be concerned about what this could mean for their bond portfolios.
The post-crisis backdrop of ultra-loose monetary policy has been kind to investors in general, but those with their money in fixed income are now particularly vulnerable to interest rate hikes. This is because the duration of the global bond market has gradually risen while yields have steadily declined.
The relationship between yield and duration is key to understanding the credit market breakeven, and its impact on bond portfolios. We can see that the credit market breakeven, calculated by dividing yield by duration, has steadily declined since 2007:
The credit market breakeven is a crude indicator that highlights the market’s sensitivity to a shock in interest rates. A lower value reflects a greater sensitivity to change. What this breakeven represents in practical terms is the extent to which government bond yields would have to rise in order to wipe out the positive total return of the global credit market over one year – in other words, how far would government bond yields have to increase before falling bond prices overwhelm the available yield, resulting in a capital loss?
The breakeven point of the all-maturities global credit universe has fallen from 98 basis points (bps) to 39bps over the last 10 years. This means the combination of lower yields and higher duration has more than doubled the interest rate sensitivity of the overall market, leaving investors more exposed to rate rises. With interest rates at major central banks on course to tick higher, leading to higher government bond yields, managing duration will only become more important.