We spoke with Income Research + Management to discuss core fixed income portfolios may be affected by inflation changes, including specific risks to insurers and risk pools.
Effect of Inflation on Core Fixed Income Portfolios
SAA: What are the risks for a core fixed income portfolio in an inflationary environment and how is IR+M positioning its portfolios to account for this?
IR+M: The recent uptick in inflation stemming from accommodative monetary policy, stimulative fiscal policy, and a world economy reopening after COVID-19 presents risks and opportunities for core fixed income portfolios. By some measures, inflation has reached its highest levels in over a decade, however, multiple metrics point to the transitory nature of the recent inflation uptick. In the near term, rising inflation erodes the income generation that bonds provide to investors, reducing the real purchasing power. This is more severe for longer-duration bonds where yields are fixed, leading to more adverse price action for existing assets in the near term, and delayed opportunity to reinvest at higher rates over the long term. Long term, the increase in inflation, and concurrent economic expansion, is likely to lead the Federal Reserve (Fed) to raise interest rates. These higher rates will likely reduce the value of core fixed income securities, all else equal, in the short term. However, bonds will benefit from higher yields in the long term, as the primary driver of fixed income returns is income. As we see in today’s fixed income markets, the drivers of fixed income prices and spreads are dynamic as the economy continues to reopen from COVID-19 and grow rapidly, with varying risks by sector and security.
With a strong economic rebound from the pandemic, demand has outpaced supply in many sectors, and materials shortages have developed in multiple segments, leading to price pressure as reflected in the most recent monthly inflation data. Sustained inflation resulting from robust economic growth may prompt the Fed to taper asset purchases and/or raise interest rates sooner than anticipated. However, continued growth may also change the credit risk profile of companies that were negatively impacted by the pandemic. For example, commercial real estate credit risk is likely to ease as travel increases, offices reopen, and consumers spend more time away from home. In addition, the pick-up in inflation helps more levered companies, especially those with fixed-rate financing, as their debt levels remain in nominal dollars and their cash flows increase at higher rates due to inflation. Inflation is likely to impact sectors and issuers differently, leading to changes in company and sector profitability, and financial conditions that will lead to repricing of core fixed income securities, presenting opportunities for bottom-up security selection. Certain companies may be more successful in passing along higher input costs to consumers. For example, higher inflation, and higher rates, could expand margins for banks. Higher rates could potentially boost book yields, and net investment income, for insurance companies as they can reinvest premiums at higher rates.
With credit spreads near historic tights, and inflation concerns high, rigorous credit analysis is paramount. In this tight spread environment, communication between our portfolio managers, research analysts, and traders is vital to uncovering mispriced securities, trading idiosyncrasies along the yield curve, and relative value opportunities. It is critical to evaluate the extension risk embedded in a security to ensure appropriate protections from the potential extended return of principal driven by reduced refinancing activity in an environment of rising rates. We see the current tightness in spreads as partially stemming from recent strong equity performance, sustained macroeconomic momentum, and a higher investor risk appetite. We believe that fixed income securities will continue to provide income and diversification benefits to investors.
We believe there are opportunities within the securitized sector, particularly in the shorter maturities within asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS). Shorter duration securitized sectors offer relatively attractive risk-adjusted yields despite the low yield environment and provide the opportunity to reinvest cash flows into potentially higher yielding alternatives, boosting book yield. Within ABS securities, we see value in non-traditional sectors such as railcars, datacenters, whole business, and collateralized loan obligations (CLOs). Similarly, we see value in vintage non-agency conduit CMBS given enhanced credit protection with minimal prepayment volatility and a well-diversified pool of collateral across property types. We believe these sectors can offer investors higher yields than similarly-rated corporates and municipals, diversification benefits, and better structural protections. Furthermore, the higher ratings within the securitized sector would typically receive better capital treatment with the NAIC. Given tight spreads, a low yield environment, and rising inflation, we are focused on staying higher quality.
SAA: Any risks specific to insurance companies or risk pools?
IR+M: Modest inflation, whether sustained or transitory, presents both near-term risks and longer-term opportunities for the insurance sector, particularly for Property and Casualty (P&C) and health insurers. Near term, inflation has the potential to pressure the cost of claims and bond prices, as inflation picks up, but investment income has not yet accelerated to keep pace. However, longer term, higher interest rates likely to accompany inflation present an opportunity to increase book yields and net investment income by reinvesting cash flows at higher rates. For the insurance sector, like other portions of the economy and the financial system, a sharp uptick in inflation and interest rates could be more credit negative than the transitory inflation increase currently expected by many financial institutions. Within the sector, companies’ specific insurance products, investment portfolios, and pricing power will likely generate different impacts on insurers cash flows and credit risk.
Insurance companies providing products in sectors of the economy with outsize inflation, such as P&C’s insuring single-family homes and autos, will face an environment where claims may rise for specific damage to these types of assets as the cost to repair and replace has risen in recent months. Likewise, health insurers are seeing more claims as medical procedures delayed during the pandemic may be increasing demand for healthcare. However, across the insurance sector, we have seen companies repricing policies and raising premiums to help offset these higher claim costs, providing a measure of protection, and demonstrating the pricing power of insurance companies as the prices of many goods and services rise.
For life insurance companies, modest inflation is likely a net positive, primarily driven by the potential for higher long-term bond yields. This increase in long-term rates would be particularly beneficial for the spread-based liabilities of life insurers, as the current record low interest rate environment has eroded the margins on these products.
At IR+M, we are focused on helping insurers mitigate these risks by relying on our bottom-up security selection, staying higher quality and shorter duration, while seeking opportunities within sectors, such as the securitized sector, that offer investors higher yields than similarly-rated corporates and municipals, diversification benefits, and better structural protections.
SAA: Are TIPS an effective hedge against inflation??
IR+M: Treasury Inflation-Protected Securities (TIPS) can offer protection against rising inflation. However, TIPS returns are more correlated to interest rates than changes in inflation. Additionally, TIPS look most attractive when deflation fears have pushed breakevens near zero as we saw last year. While TIPS can be a much more effective hedge than a fixed-rate portfolio, the potential for slippage and disconnect between inflation measures and TIPS makes them an imperfect hedge, and one that can only partially provide inflation protection to an institutional portfolio.
TIPS do well when inflation expectations are rising, or during periods of stagflation when the accruals are increasing, but real rates are stable. Often, when inflation is rising, TIPS may not perform if the Fed is raising rates and real rates are going up – the price deterioration can easily offset the accrual income benefit. When real rates rise, TIPS do not perform as well because they act like regular bonds; accrual does not help that much in that period. TIPS have longer duration than nominal bonds so price declines would likely outweigh the higher accrual. However, if inflation is rising and the Fed is not yet raising rates due to slow economic growth, TIPS can be a relatively effective hedge against stagflation. In a stagflation scenario of rising inflation without rising rates, TIPS provides the inflation accrual, however the lack of higher rates helps preserve the price of the bond. Given these dynamics, as inflation recovers, we see more relative value in spread product than in TIPS.
As of 7/23/21
The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations, or projected returns for any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.
Source: Strategic Asset Alliance, Income Research + Management The information contained herein has been obtained from sources believed to be reliable, but the accuracy of information cannot be guaranteed.