Contrary to what investors might have believed, the fund performed fairly well, even as inflation declined. By now, some readers are probably scratching their heads, but the answer to this paradox can be found right in the fund’s mission statement, which says:
“The Fund's objective is to seek to outperform the Consumer Price Index over full economic cycles.”
Nowhere does the fund state that its goal is to provide long exposure to rising inflation. It merely states a goal of “outperforming CPI over full economic cycles.” During the past year, if one took a disinflationary or even a neutral inflation stance, one would have outperformed CPI! Although we cannot see in which derivatives, such as swaps the manager has invested (derivatives markets are very opaque), but judging by the performance of the fund, the manager has probably has engaged in an inflation-neutral strategy (a strategy we have advocated for several years).
What if the environment changes and inflation begins to heat up? Although rampant inflation is not yet on the horizon, it could pose a threat someday. What would the manager do? When we look at the fund, most of the top holdings have short or intermediate maturities or average lives. The manager has positioned the fund so to be nimble should the inflation environment change.
When income is desired, we nearly always choose a portfolio of bonds over a bond fund, if for nothing else but bonds having final maturities and predictable income streams, whereas funds do not. However, where speculation, total return and, as in the case of inflation, hedging is desired, a well-constructed and well managed fund can provide the diversification (many of the MBS structures in the fund would not be available to retail investors) and discipline most investors cannot obtain on their own.
Discipline is a very important word in this discussion. All too often, when an investor asks his or her financial advisor for inflation protection, the investor believes that a position which benefits from rising inflation is needed. Most investors are not qualified to make inflation projections and could be misled by price certain price fluctuations in their daily lives which might not show up as an increase in the year-over-year change of the rate of inflation which is necessary for most CPI-linked bonds to outperform. A fund, such as this (one with which we have no connection whatsoever), can provide some inflation protection, with the discipline of trained professionals reducing the possibilities that one might be looking in the wrong direction, inflation wise.
If you would like to discuss inflation, hedging or derivatives, drop us a line.
Tom Byrne
tom@bond-squad.com.
www.bond-squad.com
www.mksense.blogspot.com
347-927-7823
Twitter: @Bond_Squad
Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.
Tuesday, September 4, 2012
Inflation Hedging? Oh Lord!
Last week, a subscriber (a very knowledgeable subscriber) asked us about the Lord Abbett Inflation Focused Fund. As a bond-oriented firm, we have not delved too deeply into funds. We understand how they work (maybe that is why we have not focused on them), but we understand that they do make sense for many investors. With this is mind, we gave the Lord Abbett Inflation Focused Fund a good going over.
Our reader’s question centered on the use of inflation-related swaps (CPI swaps, if you will), along with various fixed income instruments to, as the fund’s mission statement proclaims:
“The Fund's objective is to seek to outperform the Consumer Price Index over full economic cycles. The Fund invests in a portfolio of fixed-income securities and using a combination of inflation-indexed securities and inflation-linked derivatives to seek to maximize inflation-adjusted returns. “
After reading that, investors might expect to find a veritable cornucopia if inflation linked bonds, sitting there just waiting to reap the rewards of rising inflation. However, a quick look at the fund’s top holdings tells a different story.
Top Holdings (MHD) Position % Net
GP 8 ¼ 05/01/16 3.05k 1.080%
JPM 3.45 03/01/16 1.95k .671%
FHMS K019 A1 2.00k .662%
FH 848738 1.86k .622%
FH 848703 1.80k .592%
FH 1Q1355 1.83k .581%
DBUBS 2011-LC1A A1 1.52k .521%
C 5 ½ 04/11/13 1.53k .511%
FH 1Q1358 1.69k .507%
HPQ 4 ½ 03/01/13 1.50k .499%
There is not a single inflation-indexed bond among the top ten holdings. In fact, the only adjustable-rate securities are the four Freddie Mac MBS structures (all beginning with “FH.” The FHMS is a fixed-coupon MBS) and they float off of Libor, not CPI. If we dig down through the next 10 holdings, we find a similar story.
One also might be excused for believing that the fund would have performed poorly as inflation fell during the past year, but the data says otherwise (see the following chart):
Comparison of fund LIFFX and U.S. CPI YoY (Source: Bloomberg):
Contrary to what investors might have believed, the fund performed fairly well, even as inflation declined. By now, some readers are probably scratching their heads, but the answer to this paradox can be found right in the fund’s mission statement, which says:
“The Fund's objective is to seek to outperform the Consumer Price Index over full economic cycles.”
Nowhere does the fund state that its goal is to provide long exposure to rising inflation. It merely states a goal of “outperforming CPI over full economic cycles.” During the past year, if one took a disinflationary or even a neutral inflation stance, one would have outperformed CPI! Although we cannot see in which derivatives, such as swaps the manager has invested (derivatives markets are very opaque), but judging by the performance of the fund, the manager has probably has engaged in an inflation-neutral strategy (a strategy we have advocated for several years).
What if the environment changes and inflation begins to heat up? Although rampant inflation is not yet on the horizon, it could pose a threat someday. What would the manager do? When we look at the fund, most of the top holdings have short or intermediate maturities or average lives. The manager has positioned the fund so to be nimble should the inflation environment change.
When income is desired, we nearly always choose a portfolio of bonds over a bond fund, if for nothing else but bonds having final maturities and predictable income streams, whereas funds do not. However, where speculation, total return and, as in the case of inflation, hedging is desired, a well-constructed and well managed fund can provide the diversification (many of the MBS structures in the fund would not be available to retail investors) and discipline most investors cannot obtain on their own.
Discipline is a very important word in this discussion. All too often, when an investor asks his or her financial advisor for inflation protection, the investor believes that a position which benefits from rising inflation is needed. Most investors are not qualified to make inflation projections and could be misled by price certain price fluctuations in their daily lives which might not show up as an increase in the year-over-year change of the rate of inflation which is necessary for most CPI-linked bonds to outperform. A fund, such as this (one with which we have no connection whatsoever), can provide some inflation protection, with the discipline of trained professionals reducing the possibilities that one might be looking in the wrong direction, inflation wise.
If you would like to discuss inflation, hedging or derivatives, drop us a line.
Tom Byrne
tom@bond-squad.com.
www.bond-squad.com
www.mksense.blogspot.com
347-927-7823
Twitter: @Bond_Squad
Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.
Contrary to what investors might have believed, the fund performed fairly well, even as inflation declined. By now, some readers are probably scratching their heads, but the answer to this paradox can be found right in the fund’s mission statement, which says:
“The Fund's objective is to seek to outperform the Consumer Price Index over full economic cycles.”
Nowhere does the fund state that its goal is to provide long exposure to rising inflation. It merely states a goal of “outperforming CPI over full economic cycles.” During the past year, if one took a disinflationary or even a neutral inflation stance, one would have outperformed CPI! Although we cannot see in which derivatives, such as swaps the manager has invested (derivatives markets are very opaque), but judging by the performance of the fund, the manager has probably has engaged in an inflation-neutral strategy (a strategy we have advocated for several years).
What if the environment changes and inflation begins to heat up? Although rampant inflation is not yet on the horizon, it could pose a threat someday. What would the manager do? When we look at the fund, most of the top holdings have short or intermediate maturities or average lives. The manager has positioned the fund so to be nimble should the inflation environment change.
When income is desired, we nearly always choose a portfolio of bonds over a bond fund, if for nothing else but bonds having final maturities and predictable income streams, whereas funds do not. However, where speculation, total return and, as in the case of inflation, hedging is desired, a well-constructed and well managed fund can provide the diversification (many of the MBS structures in the fund would not be available to retail investors) and discipline most investors cannot obtain on their own.
Discipline is a very important word in this discussion. All too often, when an investor asks his or her financial advisor for inflation protection, the investor believes that a position which benefits from rising inflation is needed. Most investors are not qualified to make inflation projections and could be misled by price certain price fluctuations in their daily lives which might not show up as an increase in the year-over-year change of the rate of inflation which is necessary for most CPI-linked bonds to outperform. A fund, such as this (one with which we have no connection whatsoever), can provide some inflation protection, with the discipline of trained professionals reducing the possibilities that one might be looking in the wrong direction, inflation wise.
If you would like to discuss inflation, hedging or derivatives, drop us a line.
Tom Byrne
tom@bond-squad.com.
www.bond-squad.com
www.mksense.blogspot.com
347-927-7823
Twitter: @Bond_Squad
Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.
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