One could argue investors are spoilt for choice when it comes to looking for clues in economic and financial indicators. But some of these concepts can be difficult to understand or be misunderstood.
One term often used by fixed-income investors is breakeven. Most people will think inflation breakeven when they hear it. Did you know there is also a credit breakeven?
Understanding breakevens, both the inflation and the credit versions, could be crucial to mitigating risk.
The future of everyday bond portfolios should be considered in light of the impact of inflation, especially as interest rates remain low and inflation threatens returns.
While inflation expectations differ among the central banking elite, long-term investors are clear on the impact an even modest uptick in inflation will have on their liabilities. Chart one shows that annualised inflation of 2.5 per cent over 10 years erodes the performance of an investment by 22 per cent.
Investors should look beyond inflation surveys or central bank expectations when it comes to investment decision-making and specifically look at the inflation breakeven.
The inflation breakeven rate indicates what is priced into the market in terms of inflation expectations, and can offer investors greater clarity on what to expect.
It is not equal to inflation expectations. It is simply the difference in the price of a nominal bond and an inflation-linked bond with the same maturity. Depending on what security you are looking at, the rate differs, and therein lies an opportunity.
The breakeven is a pure indicator for monetary policy and for policy-making.
Calculating the rate
There are three inputs that go into calculating the inflation breakeven rate:
* Inflation expectations. This is by far the largest component of the breakeven. However, all inflation measures are not created equal. For example, US consumer price index (CPI) includes what households are buying, whereas UK CPI does not.
* The inflation risk premium – how much investors are willing to pay to protect their capital from erosion – reveals their view on inflation. When the breakeven is below the current inflation rate, the premium is negative; when it is above, it is positive. This is a good indication of market sentiment towards inflation.
* The liquidity premium differential. Determining this is an important indicator of how much inflation risk investors are expecting. As linkers are a government bond, the liquidity premium is generally small except during periods of crisis.
Bonds at the front of the yield and duration curve have a lower sensitivity to interest rates because they have shorter durations, but they also have lower breakevens.
This essentially makes them cheaper than longer duration products, for the same level of inflation indexation. Everyone on the curve earns the same as they are all indexed to the same rate of inflation.
Key points
- The inflation breakeven rate can offer investors greater clarity on what to expect.
- Some people are unaware there is also a credit breakeven.
- Credit breakeven shows how a value of a bond is sensitive to interest rate rises.
Taking into account measures such as the inflation breakeven and adopting a more rational approach allows investors to buy assets when they are cheap, not when they are hot.
The inflation breakeven should not, however, be confused with the credit breakeven.
More risk for less yield
Following the raft of central bank meetings in late October and early November, which confirmed interest rate rises, and with rhetoric from key policymakers firmly suggesting monetary stimulus will gradually be withdrawn, investors might be concerned about what this could mean for their bond portfolios.
The post-crisis backdrop of ultra-loose monetary policy has been kind to investors in general, but those with their money in fixed income are now particularly vulnerable to interest rate hikes.
This is because the duration of the global bond market has gradually risen while yields have steadily declined.
Yield and duration evolution
The relationship between yield and duration is key to understanding the credit market breakeven and its impact on bond portfolios. The credit market breakeven, calculated by dividing yield by duration, has steadily declined since 2007.
The credit market breakeven is a crude indicator that highlights the market’s sensitivity to a shock in interest rates.
A lower value reflects a greater sensitivity to change.
What this breakeven represents in practical terms is the extent to which government bond yields would have to rise in order to wipe out the positive total return of the global credit market over one year. In other words, how far would government bond yields have to increase before falling bond prices overwhelm the available yield, resulting in a capital loss?
The breakeven point of the all-maturities global credit universe has fallen from 98 basis points (bps) to 39bps over the past 10 years.
This means the combination of lower yields and higher duration has more than doubled the interest rate sensitivity of the overall market, leaving investors more exposed to rate rises.
With interest rates at major central banks on course to tick higher, leading to higher government bond yields, managing duration will only become more important.
Chart: Evolution of yield and duration in the G0BC (BofA ML Global Corporate Index) from 5 October 2007 to 29 September 2017
| Oct 2007 | Sep 2017 |
Yield (%) | 5.5 | 2.6 |
Duration (years) | 5.6 | 6.6 |
Breakeven (bps) | 98 | 39 |
Source: Bloomberg as at 11 October 2017
Nicholas Trindade is manager of the Axa global short duration bond strategy and Jonathan Baltora is manager of the Axa WF inflation short duration bonds
