Swiss Bond Commission How to hedge against rising inflation? Alexandre Bouchardy, CFA November, 2011 Slide 1/18
Inflation A brief summary of the recent history 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Average inflation rate since 1956 Switzerland Germany Japan United States Canada Norway France Sweden Australia United Kingdom Italy OECD average (since 1971) Spain Greece 1. Switzerland and Germany are the only countries that have achieved an average inflation rate below 3% 2. Inflation is volatile and has a positive bias. In Switzerland: Only 2 years of negative inflation -0.6% (1959) and -0.5% (2009) Peaks of close to 10% (1974), 6.5% (1981) and 5.9% (1991) Above 4% for 25% of the time, OECD Slide 2/18
Instruments providing an inflation protection Annual real return and risk of various assets: 1987 to 2009 a) Commodities and equities: attractive inflation hedge over the long term but highly volatile over the short and medium term b) Real estate: standard inflation hedge, but liquidity issues c) Inflation-linked bonds (ILB): offer the best risk/return profile Source: Barclays Capital, Credit Suisse Slide 3/18
Solution 1: Global inflation-linked bonds Advantages: 1. ILB are less risky than conventional bonds because they guarantee a real rate of return over time. 2. ILB count as a safe investment over an interest rate cycle, even safer than money market. 3. Diversification into inflation-linked bonds enhances the risk/return profile of a portfolio. 4. Provide protection against inflation uncertainty: inflation volatility and risk have massively increased in the aftermath of the financial crisis. An inflation protection is more than ever warranted. Disadvantages: 1. Lack of diversification: 3 countries/regions account for 89% of the developed market with 38% for the US, 25% for the UK and 26% for the Euro-zone (France 54%, 35% IT, 12% GE). 2. Negative performance over a period possible even though inflation increases. 3. Very long duration: the real duration of the investment universe is higher than 9, which is ill-suited for most investors. Slide 4/18
Efficient frontier optimal allocation to ILB The total volatility is significantly reduced when including ILB in a fixed income portfolio. Historical data show that the performance was very similar (period 1997-2011 H1), although this period was disinflationary. This argues for an uncompensated inflation risk, so why should someone run a risk for which he is not compensated for? The least risky portfolio had approximately 65% ILBs. 6.76% Portfolio mean return 6.75% 6.74% 6.73% 6.72% 6.71% 6.70% 100% inflation linked bonds (ILBs) 65% ILBs, 35% nominals 100% nominal bonds 6.69% 6.68% 4.40% 4.60% 4.80% 5.00% 5.20% 5.40% 5.60% Portfolio standard deviation Comparison: Barclays World Government inflation-linked Index hedged in USD vs Barclays Breakeven Index hedged in USD Historical performance indications and financial market scenarios are no guarantee for current or future performance, Bloomberg, Barclays Capital Slide 5/18
Which market conditions favour ILB? Real interest rates Inflation expectations No change in real interest rates No change in expected inflation Same performance of inflationlinked and nominal bonds. Both outperform cash. No preference Real interest rates Inflation expectations No change in real rates Rising inflation expectations Inflation-linked bonds outperform nominal bonds and cash. Best case Real interest rates Inflation expectations No change in real rates Falling inflation expectations Inflation-linked bonds underperform nominal bonds. Worst case Real interest rates Inflation expectations Rising real rates No change in expected inflation Same performance of inflationlinked and nominal bonds. Both underperform cash. No preference Slide 6/18
Solution 2: Money market investments (Switzerland) 4% 3% 2% 1% 0% -1% -2% -3% -4% -5% -6% 1956 1959 Real money market rate* 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1. Since 1956, the average real rate of return was 0.05% 2. Negative return for 36% of the time 3. Periods of prolonged negative real interest rates (1970s) 1992 1995 1998 2001 2004 2007 2010 * measured as the discount rate prevailing at the beginning of the year minus the inflation rate Source: SNB, Bloomberg, Credit Suisse Slide 7/18
Solution 3: Synthetic inflation-linked bonds Combination of conventional bonds together with inflation swaps to build synthetic inflation linked bonds Inflation protection without the sub-optimalities associated with inflationlinked bonds Benefits: ILB bond portfolio available in CHF Increased diversification as no restriction to inflation-linked bonds Increased yield by adding defensive corporate bonds Flexible and cost effective solution as no allocation change of the existing bond portfolio warranted Customized benchmark possible Precise measure of inflation risk in the portfolio Slide 8/18
Synthetic inflation-linked bonds Description Bond + inflation-swap = synthetic inflation-linked bond Principal Pay Fixed Receive Inflation Nominal Coupon we combine bonds denominated in CHF with swaps on European and US inflation. This represents a proxy hedge that works as long as inflation surprises in these markets are correlated with Swiss inflation. Slide 9/18
Measuring the interest rate risk Dual Duration We can distinguish two types of durations: real rate duration: sensitivity with respect to changes in the real rates Inflation duration: sensitivity with respect to changes in inflation expectations For nominal bonds: nominal duration = real duration = inflation duration For inflation-linked bonds: nominal duration = real duration, inflation duration = 0 To compare nominal bonds with inflation-linked bonds often an equivalent nominal duration for ILB is calculated: nominal duration of inflation-linked bonds = real duration * beta (with beta normally assumed to be = 0.5) The dual duration is the more precise measure as beta is not constant, varies across maturities and has the tendency to be directional Slide 10/18
Dual Duration Real interest rate duration Every cashflow is flagged as real and/or inflation linked Clear separation of the two interest rate dimensions Real Duration Density Cumulated Real Duration Density 1 0.8 Portfolio Benchmark 5 4.5 4 Portfolio Benchmark Spot Duration Density 0.6 0.4 0.2 0 Spot cumulated Duration Density 3.5 3 2.5 2 1.5 1 0.5-0.2 0 5 10 15 Tenor [years] 0 0 5 10 15 Tenor [years] Slide 11/18
Dual Duration Inflation duration Inflation Duration Density Cumulated Inflation Duration Density 1 0.8 Portfolio Benchmark 5 4.5 Portfolio Benchmark 4 Spot Duration Density 0.6 0.4 0.2 0-0.2 Spot cumulated Duration Density 3.5 3 2.5 2 1.5 1 0.5-0.4 0 5 10 15 Tenor [years] 0 0 5 10 15 Tenor [years] Slide 12/18
Appendix Slide 13/18
Yield curve decomposition Nominal bonds react to movements in nominal interest rates independently from the source of the change, i.e. real rates or breakeven inflation. Real bonds (ILB) react only to changes in real interest rates and are immune (protected) against changes in inflation expectations. Interest rates Nominal rate Real rate Break-even inflation Risk premium Expected inflation Slide 14/18
Inflation-linked bond non-accreting structure Non-accreting structure Maturity of the bond: 10 years Coupon: 3% (real coupon) Type: non-accreting structure, i.e. adjustment of coupons only Very few issues outstanding, mostly supranational bonds Year Inflation Notional Coupon 1 1.5 100 4.5 2 1.8 100 4.8 3 1.3 100 4.3 4 1.9 100 4.9 5 2.2 100 5.2 6 2.5 100 5.5 7 2.8 100 5.8 8 3.2 100 6.2 9 2.8 100 5.8 10 2.7 100 5.7 7.0 6.0 5.0 4.0 3.0 2.0 1.0 120 100 80 60 40 20 Graphs are just calculation examples 0.0 1 2 3 4 5 6 7 8 9 10 Coupon (lhs) Inflation (lhs) Notional (rhs) 0 Slide 15/18
Inflation-linked bond accreting structure Accreting structure Maturity of the bond: 10 years Coupon: 3% (real coupon) Type: accreting structure, i.e. adjustment of the notional only Market standard, most government bonds have an accreting structure Year Inflation Notional Coupon 1 1.5 101.5 3.045 2 1.8 103.327 3.100 3 1.3 104.6703 3.140 4 1.9 106.659 3.200 5 2.2 109.0055 3.270 6 2.5 111.7306 3.352 7 2.8 114.8591 3.446 8 3.2 118.5346 3.556 9 2.8 121.8535 3.656 10 2.7 125.1436 3.754 7.0 6.0 5.0 4.0 3.0 2.0 1.0 120 100 80 60 40 20 0.0 1 2 3 4 5 6 7 8 9 10 0 Graphs are just calculation examples Coupon (lhs) Inflation (lhs) Notional (rhs) Slide 16/18
Inflation differential Switzerland vs. France and the USA France USA EMU (since 1998) Average -2.07% -1.17% -0.97% Standard deviation 3.46% 2.55% 0.60% Correlation to Swiss inflation 0.5 0.54 0.81 5 0-5 -10-15 -20 56575859606162636465666768697071727374757677787980818283848586878889909192939495969798990001020304050607080910 Swiss minus French inflation Swiss minus US inflation Last date point: December 2009 Swiss minus EMU inflation Source: Bloomberg, Credit Suisse, OECD Slide 17/18
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