WEBVTT
1
00:00:00.035 --> 00:00:02.785 line:15%
(engine roaring)
2
00:00:05.690 --> 00:00:06.530
I'm Jenipher Nevin.
3
00:00:06.530 --> 00:00:08.616 line:15%
And today I'm joined by Jeff Carter, a portfolio manager
4
00:00:08.616 --> 00:00:11.150 line:15%
at Canso Investment Counsel.
5
00:00:11.150 --> 00:00:12.460 line:15%
Thanks for joining me today, Jeff.
6
00:00:12.460 --> 00:00:13.920
Thanks for having me, Jenipher.
7
00:00:13.920 --> 00:00:16.670
Now in the most recent version of the Market Observer,
8
00:00:16.670 --> 00:00:19.510
it talks quite extensively about inflation.
9
00:00:19.510 --> 00:00:22.380
We know inflation expectations are a major variable
10
00:00:22.380 --> 00:00:24.470
when it comes to bond investor decisions.
11
00:00:24.470 --> 00:00:25.940
So I'll ask you this.
12
00:00:25.940 --> 00:00:28.620
What does the market expect for future inflation?
13
00:00:28.620 --> 00:00:30.420
And what implication does that have
14
00:00:30.420 --> 00:00:32.720
on investing in today's bond market?
15
00:00:32.720 --> 00:00:34.110
That's a great question, Jen.
16
00:00:34.110 --> 00:00:35.907
One of the first places we look to
17
00:00:35.907 --> 00:00:38.250
for inflation expectations in the bond market
18
00:00:38.250 --> 00:00:41.050
is the US treasury inflation protected securities market,
19
00:00:41.050 --> 00:00:43.110
Otherwise known as the TIPS market.
20
00:00:43.110 --> 00:00:45.970
TIPS bonds have two return components to them.
21
00:00:45.970 --> 00:00:47.580
The first being that your principal,
22
00:00:47.580 --> 00:00:50.050
which is due back to the maturity is adjusted
23
00:00:50.050 --> 00:00:52.381
along the way for inflation
24
00:00:52.381 --> 00:00:54.770
measured by the consumer price index,
25
00:00:54.770 --> 00:00:56.670
or otherwise known as CPI.
26
00:00:56.670 --> 00:00:57.650
The other return component
27
00:00:57.650 --> 00:00:59.290
of the bond is just like any other bond.
28
00:00:59.290 --> 00:01:00.440
It's your coupon.
29
00:01:00.440 --> 00:01:04.240
And that coupon pays based on the current principal balance
30
00:01:04.240 --> 00:01:06.390
at the interest payment date.
31
00:01:06.390 --> 00:01:08.490
When we look at the TIPS market
32
00:01:08.490 --> 00:01:11.523
it implies inflation expectations of about 1.8%.
33
00:01:12.820 --> 00:01:14.900
Often people in the market refer to that
34
00:01:14.900 --> 00:01:16.680
as the break even rate.
35
00:01:16.680 --> 00:01:18.540
When we compare the inflation expectation
36
00:01:18.540 --> 00:01:22.560
of 1.8% versus the actual measured CPI in the market,
37
00:01:22.560 --> 00:01:25.260
which has recently been about 2%
38
00:01:25.260 --> 00:01:29.010
or just above 2%, that's a difference
39
00:01:29.010 --> 00:01:31.059
of about 20 basis points.
40
00:01:31.059 --> 00:01:34.240
And so when we look at regular US treasury bonds
41
00:01:34.240 --> 00:01:36.070
or nominal treasury bonds, say,
42
00:01:36.070 --> 00:01:38.820 line:15%
for example, a bond with a ten-year maturity,
43
00:01:38.820 --> 00:01:40.880 line:15%
that US government bond currently has a yield
44
00:01:40.880 --> 00:01:43.799 line:15%
of somewhere between 1.8 and 1.9%.
45
00:01:43.799 --> 00:01:48.023 line:15%
So certainly, that's close to the inflation expectation
46
00:01:48.023 --> 00:01:50.240 line:15%
of what the TIPS market implies.
47
00:01:50.240 --> 00:01:53.647
And it's actually below where the CPI is measured.
48
00:01:53.647 --> 00:01:55.770
If you look at Canada,
49
00:01:55.770 --> 00:01:59.167
that comparison is actually even a bit more pronounced.
50
00:01:59.167 --> 00:02:02.270
Currently, Canadian government bonds are trading
51
00:02:02.270 --> 00:02:04.880
with yields approximately 60 basis points
52
00:02:04.880 --> 00:02:06.380
below the actual measured
53
00:02:06.380 --> 00:02:10.300
Canadian consumer price index inflation rate.
54
00:02:10.300 --> 00:02:13.480
And so what does this all mean for bond investors?
55
00:02:13.480 --> 00:02:17.210
Well, if your real yield
56
00:02:17.210 --> 00:02:20.100
or your actual purchasing power is being eroded away
57
00:02:20.100 --> 00:02:22.220
by the rate of inflation,
58
00:02:22.220 --> 00:02:23.053
then one would ask,
59
00:02:23.053 --> 00:02:25.760
"Why would I go and buy government bonds?"
60
00:02:25.760 --> 00:02:27.640
And there's a couple of answers for that.
61
00:02:27.640 --> 00:02:31.010
First being that there's a subset of investors,
62
00:02:31.010 --> 00:02:34.440
institutional investors, such as endowment funds,
63
00:02:34.440 --> 00:02:37.860
pension funds, or other financial institutions that have
64
00:02:37.860 --> 00:02:41.970
a need and either actuarial or regulatory requirement
65
00:02:41.970 --> 00:02:43.600
to hold government bonds
66
00:02:43.600 --> 00:02:47.333
regardless of what inflation expectations are in the market.
67
00:02:47.333 --> 00:02:50.239
For investors that have a voluntary choice
68
00:02:50.239 --> 00:02:53.310
in terms of whether to hold government bonds or not,
69
00:02:53.310 --> 00:02:54.780
they need to assess the risk
70
00:02:54.780 --> 00:02:58.620
of holding these bonds in the face of inflation.
71
00:02:58.620 --> 00:03:00.590
So, if you look over, say, the past 50 years,
72
00:03:00.590 --> 00:03:03.253
the chart here displays a measurement
73
00:03:03.253 --> 00:03:06.700
of US CPI, represented by the red line,
74
00:03:06.700 --> 00:03:09.110
versus 10 year us government bond yields,
75
00:03:09.110 --> 00:03:10.953
depicted by the blue line.
76
00:03:10.953 --> 00:03:12.010
Now what's striking
77
00:03:12.010 --> 00:03:14.640
about the chart is how very few time periods
78
00:03:14.640 --> 00:03:18.410
nominal bond yields held below the rate of inflation.
79
00:03:18.410 --> 00:03:22.040
The period of inflation shocks through the 1970s was crushed
80
00:03:22.040 --> 00:03:24.190
by federal reserve rate increases
81
00:03:24.190 --> 00:03:26.390
and a corresponding sell off in the bond market,
82
00:03:26.390 --> 00:03:28.510
resulting in higher yields.
83
00:03:28.510 --> 00:03:30.530
The following 25 plus years
84
00:03:30.530 --> 00:03:33.040
leading into the financial crisis was characterized
85
00:03:33.040 --> 00:03:36.290
by a rallying bond market, but one which treated
86
00:03:36.290 --> 00:03:37.210
a healthy spread
87
00:03:37.210 --> 00:03:40.330
versus inflation, which allowed investors a reasonable,
88
00:03:40.330 --> 00:03:42.620
real, or post-inflation return.
89
00:03:42.620 --> 00:03:44.250
The environment that we have today
90
00:03:44.250 --> 00:03:48.810
where government bonds are below actual levels of inflation
91
00:03:48.810 --> 00:03:52.152
and expected levels of inflation is not the norm.
92
00:03:52.152 --> 00:03:54.110
And certainly, the implications for that
93
00:03:54.110 --> 00:03:55.819
would be an investor
94
00:03:55.819 --> 00:04:00.450
who has bonds that have a longer duration.
95
00:04:00.450 --> 00:04:04.870
They're more exposed to potential declines
96
00:04:04.870 --> 00:04:06.670
in the value of their bonds
97
00:04:06.670 --> 00:04:09.990
should we have an increase in yields relative
98
00:04:09.990 --> 00:04:12.890
to the rate of inflation that we have in the market today.
99
00:04:13.810 --> 00:04:15.510
Well, thank you for your time, Jeff.
100
00:04:15.510 --> 00:04:17.250
For more information on inflation
101
00:04:17.250 --> 00:04:18.920
and Canso's market insights,
102
00:04:18.920 --> 00:04:20.640
please go to the Canso Funds website
103
00:04:20.640 --> 00:04:23.283
and read the latest edition of the Market Observer.