The Big Idea
Inflation and fixed income performance
Steven Abrahams | February 12, 2021
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Inflation usually means bad news across fixed income, pushing up interest rates and pushing down prices and returns. But for credit exposures, inflation can reduce risk if inflated net revenues make it easier to pay off fixed nominal debt. The correlation between market inflation expectations and credit spreads suggests the market sees it that way. Rising expectations predict tighter spreads, and falling expectations predict wider spreads. Deep credit consequently may mitigate the impact of rates if inflation expectations continue to rise.
A quick study of daily inflation expectations and asset spreads from 2012 into 2021 shows a clear relationship between changing expectations and spreads:
- High yield and other leveraged credits historically have tightened the most as inflation expectations rise and widened the most when they fall
- Investment grade credits have tightened and widened more moderately as inflation expectations rise and fall, and
- Agency MBS spreads, which reflect almost no credit component, show no significant relationship to expected inflation
In other words, sensitivity to inflation expectations rises with credit risk. That is consistent with the idea that rising inflation allows borrowers to repay nominal debt more easily with inflated net revenues. Falling inflation or outright deflation does just the opposite. And this dynamic has its most pronounced impact on the most highly leveraged corporate and consumer balance sheets.
Deep credit consequently may work well in a portfolio exposed to the higher interest rates that look likely to come this year as inflation expectations rise. Tighter spreads could offset some of the price impact of higher rates. Deep credit that pays a floating coupon—leveraged loans, tranches of CLO debt, Fannie Mae and Freddie Mac CRT classes, for example—minimize the interest rate exposure to inflation and maximize the credit exposure.
Inflation expectations have varied widely since 2011. Expectations implied by the yield spread between TIPS, notes and bonds ran around the Fed’s 2% target in the early years (Exhibit 1). Expectations then dropped from mid-2014 through mid-2016 as energy prices dropped from $110 a barrel for Brent crude to a low of $27 before slowly starting to rebound. Expectations approached 2% again as the Fed hiked from December 2015 through December 2018. At that point, many in the market viewed monetary policy as too tight, and expectations started drifting lower before plunging to a post-2008 low last year with the onset of pandemic. The Fed response, fiscal policy and progress against pandemic have since pushed expectations to the highest levels since the early years.
Exhibit 1: Market inflation expectations have varied widely since 2011
It is also notable that expected 5-year inflation has usually run below 10-year inflation, and 10-year inflation below 30-year inflation. Realized inflation has run below the Fed target for much of this period, influencing expectations over the shorter horizon. Longer tenors have given more credibility to Fed intentions to get inflation back to target. Lately 5-year expectations have run above 10- and 30-year, likely reflecting the Fed’s flexible average inflation targeting approach outlined at Jackson Hole, which encourages the Fed to let inflation run hot in the near term and average 2% over a longer horizon.
The relationship between market expected inflation and risk spreads is clearest in the spreads on high yield debt. High yield spreads have broadly widened as inflation expectations drop and tighten as inflation expectations rise (Exhibit 2). That is especially clear before, during and after the 2014-2016 energy crisis and before, during and so far through the Covid-19 pandemic. Of course, this falls far short of proving that changes in expectations cause changes in spreads.
Exhibit 2: HY spreads have varied closely with inflation expectations
Investment grade corporate spreads similarly vary with expected inflation, although the moves are more muted. Investment grade spreads have generally tightened as inflation expectations rise and widened as expectations fall (Exhibit 3).
Exhibit 3: IG spreads also have varied with inflation expectations
Spreads in agency MBS, however, show a muted relationship with expected inflation. In particular, the 2014-2016 energy crisis significantly affected inflation expectations but had limited effect on the nominal spread of par 30-year MBS to the 7.5-year Treasury curve (Exhibit 4). Expected inflation and MBS spreads show more correspondence through pandemic, but this could be for reasons unique to MBS including Fed QE.
Exhibit 4: MBS spreads and expected inflation have a more muted relationship
Watching the data unfold over time still makes it hard know whether changing inflation expectations cause changing spreads or whether changing spreads cause changing expectations. Rising inflation expectations could tighten spreads as creditors stand to pay off debt with inflated revenues. But tighter spreads could also raise inflation expectations if easier financial conditions accelerate growth.
One way to start addressing causality is to look at the correlation of a change in inflation expectations during one trading session to a change in spreads in the next trading session. The broad argument is that preceding change in expectations at least has the potential to cause a later change in spreads. This is the basis for Grainger causality.
The correlations between the daily change in assets spreads—dMBS, dIG and dHY—and the change in market inflation expectations the day before—d5YBEt-1, d10YBEt-1 and d30YBEt-1—is instructive (Exhibit 5). A few things worth noting:
- Daily changes in spreads for MBS, IG and HY corporate debt are all significantly correlated. That makes intuitive sense since these assets compete to attract investors, and spreads in one asset cannot be divorced from spreads in another.
- Changes the day before in 5-, 10- and 30-year expected inflation also are significantly correlated. This also makes intuitive sense since all of these measures incorporate inflation expectations through overlapping periods
- The only significant correlations between lagged changes in inflation expectations and changes the next day in asset spreads, however, comes in HY and IG debt, and HY debt shows a stronger correlation to changing inflation expectations than does IG debt. MBS shows no significant correlation at all. The sign of the correlation between inflation and credit spreads is also as predicted: negative, since a shift up in expectations should trigger a shift down in spread and vice versa. This is consistent with the case that markets view inflation as a boon the credit, and the more leveraged the credit, the better.
The magnitude of the correlations is small but significant and likely dominated by daily changes in fundamental risk and by changing supply and demand. But it becomes more material over longer horizons. And for portfolios that cannot accommodate the low coupons and accruing principal in TIPS or invest in commodities or other traditional inflation hedges, the diversifying through credit exposure becomes more valuable.
Exhibit 5: Lagged BE and spread change correlations
Inflation looks likely to push up rates and lower prices across fixed income as the combined impact of Fed policy, fiscal stimulus and progress against pandemic drive inflation concerns. But tighter spreads can offset some of the rate impact. High yield historically has seen the most lift from rising inflation, IG corporate paper next and MBS last. The most valuable combination of rate and spread exposure may be in leveraged loans and CLOs, which combine a floating-rate coupon with leveraged credit risk. The impact of rising rates in those instruments should be limited, and the gains from tighter spreads significant. The right credit exposure stands to play an important diversifying role across a range of fixed income portfolios.
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The view in rates
Higher in the long end of the yield curve, and steeper. The Biden administration’s $1.9 trillion stimulus package has momentum, and the surge of cash and federal spending would likely push growth and concern about inflation higher. The Treasury yield curve has finished its most recent session with 2s10s at 121 bp, the highest in nearly four years, and 5s30s at 152 bp, the highest in at least five years. Inflation expectations measured by the spread between 10-year notes and TIPS have moved up 10 bp in the last week at 222 bp, the highest since mid-2014. Volatility should remain steady.
A heavy supply of cash is reducing repo rates, Treasury bill yields and LIBOR. Yields on 2-year notes have slipped lower lately despite higher rates in longer maturities.
The view in spreads
Spreads should continue to tighten slightly despite being near or at historic tights in many assets, but the highest quality assets have limited margin to tighten and plenty of margin to widen. QE absorbs MBS, the relatively riskless spread asset, at least regarding credit. Fiscal stimulus, pandemic recovery and Fed policy should also keep spreads steadily tighter through 2021. Weaker credits should outperform stronger credits, with high yield topping investment grade debt and both topping safe assets such as agency MBS and Treasury debt. Consumer credit should outperform corporate credit.
The view in credit
Consumers in aggregate are coming out of 2020 with a $5 trillion gain in net worth. Aggregate savings are up, home values are up and investment portfolios are up. Consumers have not added much debt. Although there is an underlying distribution of haves and have nots, the aggregate consumer balance sheet is strong. Corporate balance sheets have taken on substantial amounts of debt and will need earnings to rebound for either debt-to-EBITDA or EBITDA-to-interest-expense to drop back to better levels. Credit in the next few months could see some volatility as Covid begins forcing shutdown of some economic activity and distribution of vaccines potentially hits some logistical potholes. But distribution and vaccine uptake through next year should put a floor on fundamental risk with businesses and households most affected by pandemic—personal services, restaurants, leisure and entertainment, travel and hotels—bouncing back the most.