The study also showed a strong correlation between the US and Canada, the US and UK and the UK and Sweden.
Weaker correlations exist between France and Italy, France and Germany, and US and Japan.
“This does not imply investors should always invest in overseas CPI,” says Christie. “Perhaps they might consider overseas index-linked bonds to protect against inflation.”
THE FUND MANAGER’S VIEW
Chris Bowie, partner, portfolio manager, TwentyFour Asset Management, says it all depends on how exact the inflation hedge has to be.
Bowie favours RPI above CPI as it includes housing costs. Housing is very important not just for owners of property but owner’s equivalent – that is the cost of renting.
He believes the best alternative would be to use asset-backed securities (ABS) as it references Libor. As long as you believe Libor is linked to inflation, assets are going to go up.
“ABS credit or floating rate credits are a useful hedge as long as Libor moves in line with inflation,” says Bowie.
Though they didn’t in 2008 as inflation fell. While this was good for investors, it wasn’t if you were paying out.
“If you are a bit bolder, and don’t need to do an exact CPI hedge, you will find alternative assets like ABS more attractive – and cheaper – with a basis risk between Libor and CPI,” he says.
Bowie believes the US Treasury inflationprotected securities (TIPS) market has some mileage for UK investors. There is basis risk between US inflation and UK CPI, but government bonds between the two nations are highly correlated as inflation and monetary policy are relatively in step, he says.
“Over two or three years there may be a difference but over 30 years it is quite sensible. As interest rates differential is relatively small, the FX hedging cost is also small.” He is less positive about accessing bonds in Europe, though the French do issue both domestic and eurozone CPI via OATi and OATie instruments.
“Ask yourself if deflation is a potential threat in the eurozone and check the contracts to see if the coupon is scaled down or has a floor at zero,” says Bowie. “It may be well out of step with the UK’s CPI.”
THE CONSULTANT’S VIEW
For Hemal Popat, a principal at Mercer, though the concept is sound, it is really only meaningful for those who have travelled further down the de-risking road.
“The US is the obvious place to look as it’s the world’s biggest inflation market,” says P o p a t , though he doubts whether historically US CPI has been such a good hedge for UK CPI.
“Historical analysis shows that UK indexlinked gilts are a closer hedge to UK CPI linked liabilities than US TIPS so the funds do need to think carefully about the weaker correlation and whether this is compensated for through higher yield or wider active opportunity set,” says Popat. “In fact TIPS have been a slightly better hedge for UK RPI than UK CPI from a correlation perspective.”
Low UK real yields and the fact that there is a basis risk from holding UK index-linked gilts to hedge UK CPI is leading some pension funds to look at overseas inflationlinked bonds, and holding the inflation while hedging out rates and currency risks.
“Funds also need to be aware of the need for multiple collateral pools, and higher manager fees due to the additional complexity,” he adds.
So while Popat agrees TIPS have a place at certain pension funds and may be attractive at certain points in the cycle, it is also hard to see them having a structural place in the cycle.
Popat is cooler towards ABS as he says floating rate debt does not have such a great relationship with inflation, though it can offer alternative return streams and sources of attractive risk-adjusted returns.
He advises looking beyond a hedging asset, instead building a growth or return-seeking portfolio with favourable aspects from a correlation perspective.
“For funds with significant holdings of growth assets, there are opportunities to build a growth assets portfolio that will benefit from low or high inflation scenarios, through asset class and sector selection,” says Popat.
Comments