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Rising Inflation: How Should Investors React?

PART:
1 2 3 4 5
Part 2
Rising Inflation: How Should Investors React? PART 2 OF 5

Which Bond Class Tends to Do Well When Inflation Rises?

Market Realist Partner Insight: What's this? Market Realist Partner Insights is a co-produced report between prominent thought leaders in financial services along with further analysis by Market Realist research analysts. The views of the thought leader are clearly delineated from the analysis of Market Realist analysts, however, we provide a combined report for convenience to our readers.

Columbia Threadneedle Investments

Bond market signs point toward inflation and growth

Inflation is a particularly important metric for bond investors, given that most of the bond market is based on fixed rates. The main exceptions are inflation-indexed bonds like Treasury inflation-protected securities (TIPS), which have a portion of their return tied to inflation.

Signs from the market suggest that bond investors are now expecting inflation to rise in the future. David Kennedy, a Columbia Threadneedle fixed-income portfolio manager, has seen this in the yield curve, which has been getting steeper for bonds with longer maturities, and real rates (the spread between the fixed nominal rate and the rate of inflation), which are also rising. In effect, the bond market is reflecting expectations for both inflation and growth.

Which Bond Class Tends to Do Well When Inflation Rises?

Which Bond Class Tends to Do Well When Inflation Rises?

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Higher inflation rates have a negative impact on bonds. Inflation erodes the value of future coupon payments. It has more of a negative effect on bonds with later maturities.

The above graph compares the YoY (year-over-year) consumer price index inflation rate with the yields on ten-year Treasury bonds (IEF), ten-year TIPS (TIP), AAA-rated corporate bonds, and high-yield bonds over the last ten years. During that period, the correlation between inflation and Treasury yields was +0.35. It means that Treasuries underperform when inflation rises. Remember, bond yields and bond prices move in opposite directions.

Meanwhile, the correlation between inflation and ten-year TIPS was much lower at +0.1. The only difference between TIPS and Treasuries is that TIPS are inflation-protected, which explains why the yields have a lower correlation with inflation. In other words, TIPS outperform Treasuries when inflation is rising.

Meanwhile, AAA-rated bonds and high-yield bonds (JNK) had a correlation of 0 and -0.1, respectively. Corporate bonds, especially high-yield bonds, outperformed other bond classes when inflation rose in the past. While Treasuries and TIPS are only exposed to interest rate risk, corporate bonds are exposed to credit risk as well. While inflation erodes the value of high-yield bonds, they still tend to perform well because rising inflation usually means that the economy is improving. As a result, you could consider high-yield bonds when inflation is rising.

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