January 17, 2017    4 minute read

Tipping the Bond Market

A Safe Bet    January 17, 2017    4 minute read

Tipping the Bond Market

Recall the banking model pre-crisis: heads the bank wins, tails society loses. This caused mass outrage, which culminated in mass regulation, mass redundancies and massive hits to earnings. This ‘free lunch’ as economists would say, was a key feature of the crisis, but in some sense, can one blame banks for seeking to maximise profit?

After all, microeconomics teaches that firms which have a monopoly position – i.e. HSBC, Barclays and RBS – should indeed maximise earnings and set a price which is directly above from where the marginal revenue and the marginal cost curves intersect. The caveat to all of this theory is that the industry is a services industry. It is designed to serve society before it serves itself. It is a shame no one told the banks beforehand.

Inflation and Bonds

In keeping with the coin flip idea, a similar thesis can be told for the Treasury Inflation Protected Securities (TIPS) market, or rather the inflation-linked bond market. TIPS prices rally when inflation expectations rally. If the market perceives that inflation will be higher three years from now and given the worst nightmare for bonds is inflation because it erodes the purchasing power of those fixed coupons, the inflation-linked parts of the bond market will see substantial rises in popularity.

Inflation can come about in two distinct ways. Positive inflation is called ‘demand-pull’ and originates when demand for goods rises, which in turn causes producers to charge higher prices to capitalise on this boost in demand. The negative type is called ‘cost-push’ and occurs when prices of raw materials rise irrespective of the demand side.

In fact, aggregate demand might be falling as a result but, because of sudden spikes in oil or a weaker exchange rate, it causes prices to increase. Both erode purchasing power, although demand-pull is associated with higher wages to counteract this phenomenon. Cost-push, on the other hand, is negative in every sense of the word.

Solutions

So how does an investor navigate a world in which oil is likely to turn higher, Trump’s growth policies are ready in the chamber ready to be shot as soon as he assumes the hot seat at the White House and due to the uncertainty surrounding Brexit, the pound is taking a further battering, eroding domestic purchasing power? TIPS are the answer.

As an investor, all one is concerned with is income, capital gains and reasonable volatility for returns. The world at the minute is uncertain, but what is not uncertain is the fact that US rates are going up over the coming months. If they do, investors should be looking to get greater security in the capital structure by switching from high yield or stocks into inflation-linked debt, corporate or sovereign. Some say that firms with decent dividend yields that are marginally expected to increase over inflation will outperform the inflation-linked market. Think again.

First, dividends can be cut on a whim, unlike coupon payments. Secondly, if a firm’s interest expense rose on the back of higher interest rates to curb inflation, what is the first area to go? Dividends. They might be cut, but certainty would fall year on year if financial distress were to be a big issue. Even high yield would be preferable to stocks in such an environment because it is higher up the capital structure. One key thing to remember is that ‘bond proxy’ is like saying ‘cash like’, relative to cash. It is not the same thing, and in times of tightening, those differences are clear.

Conclusion

The TIPS market both in the UK and US should yield sizable returns in 2017 and 2018. In the UK, if the economy does suffer from a weaker GDP and a weaker currency, inflation will rise boosting the TIPS market. In the US, if demand-pull inflation does come through, again the inflation-linked bond market will do well too.

Heads TIPS win, tails TIPS win.

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