(Risk.net) - Dmitry Pugachevsky, director of research at Quantifi, explores how banks manage inflation risk using inflation swaps and inflation-linked bonds as hedging instruments The US Consumer Price Index (CPI) March 2023 report unleashed a wave of buying in stock markets.
At 5% year-on-year, the CPI was better than many economists had predicted and was a full 100 basis points lower than the previous reading in February. Wholesale prices also declined 0.5% in March, due largely to more benign energy prices.
So, it seemed inflation was on the way to being tamed and the US Federal Reserve might not only put a halt to the remorseless hiking pattern of previous years, but even move into a more accommodating monetary policy stance.
While the CPI might have been at 5%, the core rate excluding the volatile elements of food and energy was 60bp higher at 5.6% year-on-year – not quite so encouraging. A recent New York Times feature presents a year-on-year percentage change in the CPI and sets out how the levels were still considerably higher than the US has experienced for 40 years.
Inflation can erode the value of investments and reduce the purchasing power of cashflows. Fixed income investments particularly bear the brunt of this. By hedging against inflation risk, buy- and sell-side firms can ensure they have a more predictable cashflow and can better manage their overall risk exposure.
Banks use inflation swaps as a tool to hedge inflation risk in their portfolios. This provides a fixed cashflow for the bank, even if inflation rates rise unexpectedly. Inflation swaps can be customised to meet the specific needs of the bank, allowing them to tailor the swap to their unique inflation risk profile. Banks also use inflation-linked bonds to help them maintain the real value of their investments in times of inflation.
Inflation-linked bonds are issued by governments and linked to inflation indexes of the issuing country. In the US, Treasury Inflation-Protected Securities (Tips) are linked to the CPI while, in the UK, index-linked gilts are linked to the Retail Price Index.
Most inflation-linked bonds are accreting bonds whereby the notionals applied to coupon and redemption payments accrue according to some indexation method. There are several indexation methods, used by different jurisdictions: for example, ‘gilt old style’ in the UK (on issuances before 2005) and ‘Canadian method’ for US and most other bonds, including the UK after 2005.
Australian inflation bonds have two types of indexation: capital indexed bonds and indexed annuity bonds. Each of these methods vary based on the formula used to calculate the index ratio and the time intervals between the publishing of the index and coupon accrual period end-date or bond redemption date. For example, gilt old style assumes eight months’ lag, while the Canadian method assumes between two and three months. Additionally, there are disparities in interpolation methods. The UK gilt method assumes flat value throughout the month, while the Canadian method interpolates between indexes published two and three months before the payment date. More information about Tips and linkers and the historical value of indexes is available from the Treasury Direct and UK Debt Management Office websites.
Inflation-linked bonds have both real and nominal yields. The real yield of an inflation-linked bond is the yield adjusted for inflation, while the nominal yield is the yield before adjusting for inflation. Understanding the relationship between real and nominal yields is crucial for investors to make informed decisions regarding their portfolios’ inflation risk.
Real versus nominal yields
As with regular treasury (TSY) bonds, inflation-linked bonds can be priced using the market and model approaches. The market approach converts market price to yield, and vice versa, without taking inflation into account. The resulting yield is called ‘real yield’. When the inflation rate is positive, Tips prices tend to be higher despite having lower coupons than TSY bonds. As a result, the real yields of Tips are typically lower than those of TSY yields.
The difference in yield is a good estimation of inflation expectation. For example, if Tips with 1% coupon have a market price of 100 – in other words par – then real yield is 1%. Compare this with a TSY bond, with the same maturity and yield of, for example 4%, one can expect the inflation rate to be around 3%.
To gain a better understanding of the relative value of Tips bonds, vis-à-vis either other Tips bonds or TSY bonds, one must use the model approach. This approach requires building and applying an inflation curve and then deriving yields from market prices using the accreting bond formula. The yields obtained from the model method are referred to as ‘nominal yields’. They are constructed to closely approximate real yields plus the inflation rate, and are thus comparable to TSY yields of similar maturity. Continuing with the the aforementioned example, suppose the 3% inflation curve is input to the accreting bond pricing model, and the yield is calculated for a bond priced at par. The resulting nominal yield will be close to 4%. The connection between real and nominal yields helps explain the behaviour of Tips prices when the expectation of inflation grows rapidly. In such scenarios, Tips prices may remain stable or even decrease. The reason for this is that, when inflation rises, TSY yields and Tips nominal yields also rise, therefore real yields remain stable or can increase.
Merely comparing yields is not enough to conduct successful relative-value trading. To fully comprehend the situation, an advanced model approach is required, which involves constructing two curves – a discounting index return curve and an inflation curve. It is important to note that credit risk is generally disregarded for inflation-linked bonds, as they are government bonds. However, to accurately align with the market price of Tips, it is necessary to consider the z-spread. In this instance, the z-spread reflects the risks involved, such as liquidity risk, when buying inflation bonds. This approach is equivalent to a formula well known in economics.
The discount curve can be constructed from TSY bonds or from Fed fund swaps, depending on how future cashflows will be hedged. Similarly, one can calibrate the inflation curve to market prices of inflation bonds or to other inflation instruments such as zero-coupon swaps.
Trading and hedging inflation-linked instruments requires an advanced model library such as Quantifi’s. In addition to zero-coupon swaps, there are other varieties of inflation-linked derivatives in the market, such as year-on-year swaps, the pricing of which requires convexity adjustments for inflation curve. There are more complex payoffs for Tips, such as having either their coupon payments or a principal payment floored. In addition to price-to-yield and yield-to-price calculations, other metrics, such as yield duration, yield convexity and even weighted average life, are required for estimating relative values and risks of inflation-linked bonds. A strong middle-office function is also important for firms trading and hedging inflation-linked instruments, as it helps ensure accurate risk management, efficient trade processing and timely reporting of all historical payments and index values. This helps mitigate potential losses, while also providing valuable insights for decision-making.
The buy and sell sides have access to a range of products that hedge inflation and pay higher returns in line with higher inflation. They have not been the most popular products on the shelf for some time, but that is changing. Inflation modelling is crucial for financial firms because it enables them to better understand and manage the risks associated with inflation.
Inflation can have a significant impact on various financial instruments, including bonds, equities, derivatives and other investments. By accurately modelling inflation, firms can better forecast future inflation rates, identify potential opportunities or risks and manage their portfolios accordingly.
While inflation might have receded from its peak, it is still too high for comfort, particularly because, as we have seen, it could well stay at these levels for some time. It’s time to dust off linkers and Tips.
May 10, 2023