Diversifying market risk in uncertainty

As investors and economists peer into their crystal balls to determine whether we will have deflationary or inflationary economic pressures in 2024 and beyond, the truth is that we simply do not know. It is not that history does not give us a guide; it does. Whether commercial transactions take place in a local street market or the stock market, all reflect human endeavour and behaviour. But until our current recovery from the great financial crisis of 2009, we have never been in an economic recovery with so much excessive indebtedness.

The main four central banks and government treasury departments, once independent, are now joined at the political hip. Having lost all desire to balance a budget, they are happy to keep printing an unlimited amount of fiat money, further driving up debt which can never be repaid. Well aware that in this scenario, the currency becomes the victim; central banks have been aggressive buyers of gold bullion, the only sound money during the last 10 years.

With US treasury bonds giving a risk-free interest of around 5% per annum and with so much uncertainty, many investors prefer to hold low risk cash equivalents rather than risk assets. The index-linked treasury bonds (TIPs) can act as a diversifier in portfolios and give protection in times of inflation and some protection in times of deflation. A relatively new class of security, TIPs are by far the largest and most liquid market in the US. The UK, Switzerland and Germany all issue similar index-linked government bonds with negligible risk of default.

Treasury Inflation-Protected Securities (TIPs) offer unlimited potential outperformance over treasuries in inflationary environments, while regular treasuries only offer limited potential outperformance over TIPS in deflationary environments. The limited treasury outperformance during deflation is because TIPS have a deflation floor. At maturity, a TIPS investor receives the higher of the adjusted principal value or the original principal value.

The deflation floor is most relevant for newly issued TIPS with principal values close to par (100). Bonds are issued at par and redeemed at maturity. They also offer some protection in a deflationary cycle because the nominal (the capital you put in) will be paid at par as long as the issuer does not default. TIPS will return the nominal at maturity with an increased purchasing power. In times of inflation, capital is protected as the nominal increases with inflation. Though based on the CPI index, which does not measure inflation accurately, the purchasing power of capital will nevertheless increase with inflation and not decrease.

The most important thing to remember about TIPS is that they protect against unexpected inflation.

Inflation-linked bonds are one of the few assets that have historically worked in economic environments of declining growth and in rising inflation. A traditional asset allocation for baby boomers of 55% in a regular bond exposure will significantly underperform if inflation accelerates. Portfolios structured for all potential economic environments need TIPS to bring unique inflation hedging characteristics.

Jeremy Blatch TEP
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