What Happens to My Bonds When Interest Rates Rise?

 What Happens to My Bonds When Interest Rates Rise?


Interest rates have been on an upward trend lately, and because of that, we've been getting more questions around the impact of rising rates on a bond portfolio. And the short answer to the question, "what will happen to my bond portfolio when interest rates rise?" is simply this: it depends. And the reason that it depends is because not all bonds are created equal. Some bonds have very high levels of sensitivity to interest rates. These might be long term bonds, 30 years or more. Other bonds have very little sensitivity to interest rates.

Maybe these are one year bonds or two year bonds. And the key when it comes to managing a bond portfolio is matching the bonds that you own to your objectives. Most individuals will find that their objectives are best suited by short and intermediate term bonds. Maybe those are anywhere from one year to 10 years. Other individuals may own longer term bonds, but that comes with the realization that they will be more susceptible to rising interest rates. When interest rates rise, however, there are two impacts on a bond portfolio. The first is that, in the short run, prices do fall. As interest rates go higher, bond prices decline. But the second impact is sometimes hidden, and it's simply this: over time in a rising interest rate environment, the income from a portfolio increases. That's because bonds are constantly maturing, or kicking off income streams in the form of coupon payments. As that income and those maturities are reinvested at ever higher interest rates, the yield on your bond portfolio increases.

And so what many people may find is that, over the course of an interest rate cycle, the path of their bond portfolio will look something like a U. Initially, the value will decline as price losses from the bonds outweigh any gains in income. But over time, those higher income levels offset price declines and result in a net asset value, or a value of your bond portfolio, of perhaps equal to or greater than where you started. Ultimately in fact, rising interest rates are an investor's friend because of this: an investor has a choice of whether or not to take a loss in a bond portfolio if it's due to an increase in interest rates.

And what I mean by that is that when a bond defaults, if it's a lower credit quality bond, an investor has no choice whether or not to recognize the loss. And that loss is a permanent impairment of their capital. But with interest rates, because of the fact that bond proceeds can be reinvested into the portfolio, interest rate movements are self-correcting. Investors have a choice of whether or not to recognize losses. And if they don't recognize their losses, then any temporary declines are simply that: a temporary impairment of their capital. And so rising interest rates are nothing to fear, provided the average maturity and the composition of your bond portfolio matches your goals. If your time horizon and your financial goals match your bond portfolio, in fact, rising interest rates are your friend. Think about it this way. What's going to provide more income: higher interest rates or lower interest rates? The answer of course is self-evident. And if you have a financial goal that involves getting a certain required rate of return, higher interest rates are going to move you closer to that financial goal. And that's why starting with a financial plan which identifies your goals, following that up with a bond portfolio - if you own bonds, if they're appropriate for you - that matches your goals, and then staying the course in those high quality bonds is the best thing that most investors can do, and is going to give them the highest opportunity to meet their financial goals.

So again, rising interest rates and some of the rhetoric that comes from it, especially out there in the media, some of the paranoia, some of the hyperbole - can sometimes prompt fear that, "oh my goodness, my bond portfolio is going to collapse in value." But the truth of the matter is that if your bonds are short and intermediate term, and if they're appropriate to your time horizon, rising interest rates are your friend, not your enemy, and are going to increase your odds of meeting her financial goals.




pure financial, pure financial advisors, your money your wealth, financial planning san diego, financial planning sherman oaks, financial planning brea, what happens to bonds when interest rates go up, Why do bond prices go down when interest rates go up?, What is the relationship between bond prices and interest rates?, if interest rates rise what happens to bond prices, stock market volatility 2018, stock market volatility explained

Inflation-indexed bond

Inflation-indexed bond

Daily inflation-indexed bonds are bonds where the principal is indexed to inflation or deflation on a daily basis in terms of the official Daily CPI or monetized daily indexed unit of account like the Unidad de Fomento in Chile and the Real Value unit if Colombia. They are thus designed to cut out the inflation risk of a bond. The first known inflation-indexed bond was issued by the Massachusetts Bay Company in 1780.

The market has grown dramatically since the British government began issuing inflation-linked Gilts in 1981. As of 2008, government-issued inflation-linked bonds comprise over $trillion of the international debt market. The inflation-linked market primarily consists of sovereign bonds, with privately issued inflation-linked bonds constituting a small portion of the market. Structure Daily inflation-indexed bonds pay a periodic coupon that is equal to the product of the daily inflation index and the nominal coupon rate. The relationship between coupon payments, breakeven daily inflation and real interest rates is given by the Fisher equation.

A rise in coupon payments is a result of an increase in inflation expectations, real rates, or both. For some bonds, such as the Series I Savings Bonds, the interest rate is adjusted according to daily inflation. For other bonds, such as in the case of TIPS, the underlying principal of the bond changes, which results in a higher interest payment when multiplied by the same rate.

For example, if the annual coupon of the bond were 5% and the underlying principal of the bond were 100 units, the annual payment would be 5 units. If the inflation index increased by 10%, the principal of the bond would increase to 110 units. The coupon rate would remain at 5%, resulting in an interest payment of 110 x 5% = units. Real Yield The real yield of any bond is the annualized growth rate, less the rate of inflation over the same period. This calculation is often difficult in principle in the case of a nominal bond, because the yields of such a bond are specified for future periods in nominal terms, while the inflation over the period is an unknown rate at the time of the calculation.

However, in the case of inflation-indexed bonds such as TIPS, the bond yield is specified as a rate in excess of inflation, so the real yield can be easily calculated using a standard bond calculation formula. Global issuance The most liquid instruments are Treasury Inflation-Protected Securities, a type of US Treasury security, with about $500 billion in issuance. The other important inflation-linked markets are the UK Index-linked Gilts with over $300 billion outstanding and the French OATi/OAT€i market with about $200 billion outstanding. Germany, Canada, Greece, Australia, Italy, Japan, Sweden and Iceland also issue inflation-indexed bonds, as well as a number of Emerging Markets, most prominently Brazil.

Inflation-indexed bond indices Inflation-indexed bond indices include the family of Barclays Inflation Linked Bond Indices, such as the Barclays Inflation Linked Euro Government Bond Indices, and the Lehman Brothers U.S. Treasury: U.S. TIPS index. See also Fisher equation Constant Item Purchasing Power Accounting References External links TIPS U.S. Series I Savings Bonds Inflation-linked Gilts Print Deacon, Mark, Andrew Derry, and Dariush Mirfendereski; Inflation-Indexed Securities: Bonds, Swaps, and Other Derivatives Wiley Finance. ISBN 0-470-86812-0. Benaben, Brice, and Sebastien Goldenberg; Inflation Risks and Products Riskbooks. ISBN 978-1-906348-07-6. Canty, Paul and Markus Heider; "Inflation Markets: A Comprehensive and Cohesive Guide" Risk Books. ISBN 9781906348755. .

Currency Exchange Rates and Investing Offshore

 Currency Exchange Rates and Investing Offshore


There is a definite profitable advantage to be had when seeking favorable currency exchange rates and investing offshore. This applies to specific offshore investment ideas such as vacation rental property and stocks and to foreign direct investment on a larger scale. Using Colombia and the current state of the Colombian peso as an example we look at currency exchange rates and investing offshore. The USD COP Exchange Rate As of early March, 2015 the USD COP exchange rate is just under 2,600 Colombian pesos (COP) to the dollar (USD). As a point of comparison the peso traded 1818 to a dollar two years ago and again around 1820 just 7 months ago. Go to ExchangeRates.org and pick the two year history for the USD COP exchange rate history. Welcome to the USD COP history summary. This is the US Dollar (USD) to Colombian Peso (COP) exchange rate history summary page, detailing… The point being that the peso has fallen dramatically over the last several months.

Why is that? Colombia is an oil producer and the Colombian peso is closely tied to the price of oil. The Price of Oil Falls Take a look at the chart on InvestmentMine.org for a five year crude oil price chart. The page lists the current price and 52 week highs and lows. Our interest is in the chart. Crude Oil Price USD/bbl (EUR/bbl) 09 Mar 2015 - 52 Week Low USD/bbl 52 Week High 1USD/bbl The point is that oil was selling for around $110 a barrel in July of 2014 at the same time that the Colombian peso was trading 1800 to a dollar. Oversupply and the presence of threat of recession in Europe, China and Japan have reduced demand at the same time that two main producers, Saudi Arabia and the USA are pumping like mad. Colombia has been caught in this dilemma. Until the price of oil goes up the Colombian peso will be hurting.

And what does this have to with currency exchange rates and investing offshore? Investing in Colombia Colombia is a democracy with a well-managed economy. The half century long civil war may well be drawing to an end as talks between the government and main rebel faction, FARC, continue in Havana. Colombia is a big energy exporter to the USA, has a free trade agreement with the USA as well as the Pacific Alliance of Chile, Colombia, Mexico and Peru. Direct foreign investment in the oil and gas sector peaked at $13 billion in 2013. Take a look at the CIA World Factbook page for Colombia and click the Economy tab. Colombia's consistently sound economic policies and aggressive promotion of free trade agreements in recent years have bolstered its ability to weather external shocks. Real GDP has grown more than 4% per year for the past three years, continuing almost a decade of strong economic performance. All three major ratings agencies have upgraded Colombia's government debt to investment grade.

Nevertheless, Colombia depends heavily on energy and mining exports, making it vulnerable to a drop in commodity prices. Colombia is the world's fourth largest coal exporter and Latin America’s fourth largest oil producer. The point is that there is the basis for profitable investment in Colombia and now is an ideal time because of the fall in value of the Colombian peso, property in Colombia and business investment in Colombia due to the current weakness of the Colombian peso. There is vacation property in Cartagena on the Caribbean and business investments in the 8 million person city of Bogota. The coffee producing and agricultural region around Manizales, Pereira, Medellin and Cali is an often overlooked area for investment as well.

Because the price of oil is cyclical we can expect to it to rise from current lows and bring the value of the Colombian peso back up with it. Simply as a Forex play one might convert their dollars to COP and bank them in Colombia while waiting for an investment opportunity. If the opportunity does not occur one could wait for the expected return of the COP to the 1,600 to 1,800 to the dollar range and simply convert back to dollars with a fifty percent profit! That is our point about currency exchange rates and investing offshore.



currency exchange rates and investing offshore, forex, foreign direct investment

Tables of historical exchange rates to the United States dollar

 Tables of historical exchange rates to the United States dollar

Listed below is a table of historical exchange rates relative to the U.S. dollar, at present the most widely traded currency in the world. An exchange rate represents the value of one currency in another. An exchange rate between two currencies fluctuates over time. The value of a currency relative to a third currency may be obtained by dividing one U.S. dollar rate by another. For example if there are ¥120 to the dollar and €to the dollar then the number of yen per euro is 120/= 100. The magnitude of the numbers in the list do not indicate, by themselves, the strength or weakness of a particular currency.

For example the U.S. dollar could be rebased tomorrow so that 1 new dollar was worth 100 old dollars. Then all the numbers in the table would be multiplied by one hundred, but it does not mean all the world's currencies just got weaker. However it is useful to look at the variation over time of a particular exchange rate. If the number consistently increases through time, then it is a strong indication that the economy of the country or countries using that currency are in a less robust state than that of the United States. The exchange rates of advanced economies, such as those of Japan or Hong Kong, against the dollar tend to fluctuate up and down, representing much shorter-term relative economic strengths, rather than move consistently in a particular direction. The data is taken from varying times of the year or may be the average for the whole year. Some of the data for the years 1997-2002 refers to the rate on, or close to, January 1 of that year.

Some of the data for 2003 refers to rates on May 28 for countries beginning with A-E, and June 2 for countries listed F-Z. Exchange rates can vary considerably even within a year and so current rates may differ markedly from those shown here. Caveat lector. Table for 1840 to 2009 Table for recent years See also Bretton Woods system for more exchange rates 1945 to 1971 Gold standard for exchange rates around 1900 for currencies using the gold standard Fixed exchange rates to the euro Currency pair ISO 4217 currency codes Historical exchange rates of Argentine currency Footnotes Notations  This article incorporates public domain material from websites or documents of the CIA World Factbook. The 2003 data was taken from Pacific Exchange Rate Service The graph back to 1969 was generated using data from the Reserve Bank of Australia External links Historical Currency and other charts since 1999 until today USD Historical Rates for last month Historical currency exchange rates going back 5 years Historical Exchange Rates Forex Rates Today Foreign Currency Units per 1 U.S.

Dollar, 1948 - 2007 .

CPI index | Inflation | Finance & Capital Markets | Khan Academy

CPI index | Inflation | Finance & Capital Markets | Khan Academy


Everyone's talking about inflation and deflation these days, including myself, and that's because it's important. And in order to really have an informed view on it, I think it's important to actually look at how inflation is defined. And right here, I actually took a screenshot from my Bloomberg terminal, of the basket of goods that makes up the Consumer Price Index. The index that sets everything from the coupons on Treasury inflation-protected securities-- this is the index that dictates what Social Security payments are, how fast they're going to grow. I'm sure a bunch of union agreements and pension agreements are dependant on the CPI. So this is the underlying basket of goods that really tells us what inflation is. At a first level, it's just fun to look at, because you can compare your own household to what the government thinks is a typical household. For example, the government says that the typical household spends 15.7% of their disposable income on-- and that's essentially the income that you take home after paying taxes-- that they spend 15.7% on food and beverages. That seems reasonable. What's even more interesting is that they break it down. They get very granular.

They try to figure out how much do you spend on eggs, and fish, and poultry, and bakery products. And that's good because, let's say, everything else stays constant, but the price of eggs goes through the roof because the Atkins diet becomes popular again. Then you can actually make an informed decision as to why inflation is going up or whether inflation will go up going forward. So that's just interesting to look at. If you look at the major categories. They have food and beverages, housing-- And I'm going to come back to housing because this is, in general, just a very interesting area to focus on, because it makes such a big portion of the CPI. And it's been such a big portion of the economic picture, especially the last 10 years. And obviously, it's become a big problem, has become a big factor, in terms of what's causing the financial crisis right now. But housing is about 43% of disposable income. Apparel: 3%. Transportation: 15%.

This includes things like new vehicles, 4%, used cars and trucks. And I think the way they calculate this is, they say, what percentage of Americans are driving new vehicles versus used vehicles? And they put fuel in here. A lot of people, when I have this inflation-deflation argument, they make this argument that China and India are going to continue growing. And because of that, commodities like oil and fuel will continue to increase. Although people were making that argument more last summer, but even now people are making that argument. But in a developed country, you see that motor fuel, even though it hits your pocketbook on the margin, it isn't that big a part of your total expenditure.

Especially when you compare it to things like housing. And if you keep going down, medical care: 6%. And then recreation. They break it down and you could look this up. I think the Bureau Of Labor Statistics has this broken down as well, although it was much easier to get it on the Bloomberg terminal. Education: on average, 3%. Obviously, if you're sending your kids to college that's a much higher number, but, on average, if you take the average household. And finally, other goods and services: tobacco, et cetera, et cetera.

So that one is just interesting to look at. So whenever you have a discussion on the things that may or may not drive inflation, it's important to weigh them by these weightings that the CPI gives them, to figure out what the actual impact on how we measure inflation really will be. With that said, if you think about it, really the biggest portion of this is the housing piece. I think that's fair. Housing is a large percentage of most people's disposable income, especially in a Western society. You can imagine, if you live in a Third World country, and you're barely getting by, food might be a huge part of your expenditure, maybe rivaling housing if you've just kind of built a house someplace. But in a developed society, housing is a huge percentage of it. And I want to focus on one thing, and a lot of people have talked about this. And actually Mish once again, from Global Economic Analysis, he really encouraged me to highlight this. So within housing, obviously some people rent, some people buy. And so they give a 6% weighting of the whole basket to rent, and then they give a roughly 24%, 25% weighting to something that they call, owners' equivalent of rent of primary residence.

So this is essentially their attempt to measure how much it costs to live for people who own houses. What's interesting, and you probably have caught onto it, is they use the words: owners' equivalent rent. So what they do, and this is the current methodology, they don't say, how much is your mortgage? They don't say, how much does it cost you to buy the house and amortize it over the reasonable life of the house? They actually just say, how much would it cost to rent that house? And they've kept waffling back and forth between-- sometimes they just look for equivalent houses, and they say, well, how much would that cost to rent? At one point they were actually surveying people and they would ask them, how much would it cost to rent your house? Which is probably even a worse number. But the bottom line is, they're not factoring in actual mortgages.

And you can even see it on the weighting. Right when I looked at these numbers, I was like, well, roughly 66% of people own houses. How come this number isn't 66% relative to this number, right? It's closer to 80%. I was like, oh, I know that's fair because more people actually live in homes. You could say that 66% of overall households own, but, in general, homes are bigger, there might be more people in it. So you could either think of it on a person basis or maybe on a square footage basis. It makes a little bit more sense to weight houses higher.

But what's interesting here, is that this number, especially if you add these two, housing in general is about 30% of disposable income. And traditionally that was the rule that a bank would use to decide whether you can afford a house. It shouldn't be more than a third of your disposal income, or at least a mortgage payment shouldn't be more than a third. We know, especially over this last real estate bubble, that's become a much, much larger percentage of people's actual disposal income. So you wonder, why is this weighting only 30% of disposable income? Well, that's because they use owners' equivalent rent. They didn't actually say what people's mortgage payments are. So even though mortgage payments might be going through the roof, even though the price of a house might be going through the roof, it does not get reflected in the CPI number as of the early `80s.

This is straight from the Bureau Of Labor Statistics website. And they wrote-- and they're actually using doublespeak here, I just copied and pasted it straight from their website --"until the early 1980s, the CPI used what is called the asset price method to measure the change in the cost of owner-occupied housing." That makes sense and I'm not sure whether they just looked at how much houses cost this year relative to last year and then they put that into the weighting or they determined the weighting based on people's average mortgage. But in general, that's a good way to measure it, right? Either your mortgage payment, or how much houses cost. They said, "the asset price method treats the purchase of an asset, such as a house, as it does the purchase of any consumer good." Fair enough.

"Because the asset price method can lead to inappropriate results--" And this is the key line. "Because the asset price method can lead to inappropriate results for goods that are purchased largely for investment reasons." I agree with that. If something is purchased largely for investment reasons, if I'm purchasing gold, maybe that shouldn't be included in the CPI, because it's largely for investment reasons or for stocks.

But then they use this kind of completely disjointed logic. They say, you know, "because asset price method can lead to inappropriate results for goods that are purchased largely for investment reasons, the CPI implemented the rental equivalence approach to measuring price change for owner-occupied housing." To me, that makes no sense. Owner-occupied is not purchased for investment reasons. That's a fair enough argument if you're doing it for rentals, or if you're doing it for vacation homes. But for actual owner-occupied housing, this sentence makes no sense.

Based on their own rationale, there's no reason to transfer to this rental equivalent approach. The whole reason why I'm going here is, because in the early `80s, I think 1983-- they say it right here, in January, 1983-- because they switched over to this, this kind of inflation that we've seen in the price of houses, especially the real estate bubble we've seen the last 10 years, in no way got incorporated into the inflation numbers. So it essentially understated them. You can see that here. Well, two things: not only did it understate it, but it probably understated the weighting itself. And Mish, he's had a couple of posts about this. You really should use something like the Case-Shiller Index on this line right here, instead of doing this for owners' equivalent. But I'd argue one step further. Not only should you use something like the Case-Shiller Index, but to actually gauge this weighting, you should actually survey people and say, what percentage of your disposable income is dedicated to your mortgage and other things related to owning a house? And especially over the last seven years, I would guess, and I'm almost sure about this, that it would be much larger than 30% of your disposal income.

So not only was this number being understated, or the growth in that number, because it didn't incorporate the increase in housing prices, but this weighting itself was understated. And just to get a sense of how much, this is the Case-Shiller Index. And you could look up the Case-Shiller Index, but, in my opinion, it's the best index for actual increases or decreases in the price of homes. You see from 2001 to 2006 roughly, houses were increasing by 10% to 15% a year. So if you use that instead of the rental equivalent, then over the same timeframe-- I don't have a chart for rent, but rent was not increasing at anywhere near this pace. If anything, people were leaving apartments to buy houses, so rent was actually staying pretty stable. But 10% to 15%-- this is year over year growth, this is what this chart is. So 10% to 15%, if you weight that at 30% of the CPI basket, then really the reported inflation number was being understated by 3% to 5% a year. And I'd argue that this weighting should have grown over that time period because people were spending more and more of their disposable income on their mortgage payments.

So really it was probably understanding it by more. Then this weighting should've been more like 40% and you could have said you're understanding it by 4% to 6%. And if you look here, this is the actual reported CPI numbers. What I'm saying is, over that timeframe, the real inflation number should have been up here. And then, now that we have actual deflation in home prices, this is zero. So now, the most recent Case-Shiller numbers say that housing has depreciated by 20%. We're essentially understating the deflation now. So although right now the CPI has us at kind of the zero mark, if you actually incorporated the real prices of homes and you didn't use rents as a proxy for it, you would actually get a much more negative number here. And Mish actually did that on his blog. And if you actually want to read his blog, which I highly recommend, do a Google search for Mish, M-I-S-H. And this is directly from his blog, so I have to give him credit for that. And what he did here is, he actually charted the actual inflation numbers that were reported. That's in blue.

And then on top of that, he put what he calls the Case-Shiller CPI Index and that's in red. And you see here, especially over the housing boom-- These are the inflation numbers we got from the government. They peaked out in the 4% or 5% range, which isn't low by any stretch of the imagination, and that's probably why the Feds started increasing interest rates right around here, arguably at the worst possible time. But if you look at the CS CPI, or the Case-Shiller CPI, you could almost say that the real inflation actually peaked out in the 8% range back here. And you could argue that, if this was the actual number that the Fed was using, it would have actually been a much better policy tool, because they would have seen the inflation pop up back here in January '03.

And they would have known that they were keeping their monetary policy too loose back here and they could've avoided this whipsawing that they did and in 2007 and 2008. And I'd argue even further that even this number is understanding the reality, because back here, as a percentage of the actual CPI basket, he just took the CPI numbers and replaced the year over year change essentially into the same weighting as the current CPI numbers. But if you actually weighted it based on the actual amount of disposable income people were spending on their mortgages, I would guess that it would have looked something more like this.

And you would have seen actual inflation peak out here, probably in the 10% or 11% range. There's a lot of social commentary about this; why they do it. One argument is, that a lot of the government's or even corporate liabilities are indexed to inflation. You have an inflation index. On the other hand, the sale of homes essentially transfers wealth from one generation to another. Especially when you have a huge increase in the price of homes. If they did this on purpose, and I'm guessing that they did, it allows housing prices to increase dramatically. And when housing prices increase dramatically, it transfers wealth from the new buyer generation to the retiree generation, so it helps subsidize the retirees. And, at the same time, by taking it out of the actual CPI index, it keeps the government's, and actually a lot of other corporate, liabilities low. Because now Social Security, it's indexed to the CPI numbers. So if the CPI numbers are not incorporating, are not raising up here, you don't have to increase people's Social Security payments.

And you kind of get to project this farce to people. You say, oh, in inflation adjusted terms, you're doing better than your parents' generation did. Oh, but, by the way, you can afford 1/3 the house now. And to some degree that's been propagated-- it's obviously all falling apart now. But the big takeaway from this, if I had to give you just one, is that the CPI index is a government created tool. It's based on a survey and, not only has it not been the same survey, but it's actively changed over the years. And it's changed in ways that significantly impact the actual numbers that are reported and, to some degree, play into what I think the government wants people to believe.

Index Linked Bonds and Inflation Derivatives

 Index Linked Bonds and Inflation Derivatives



In 97 the market for index-linked products has grown enormously in the 2000s where the derivatives market started up and since about 2003 we've had a very active derivatives market in a range of products and swaps being the most illiquid and more recently as it's about o 7 we've had inflation options which are trading fairly liquidly as well now inflation's become of grow great of interest recently in the markets because of course we have two factors which are very much in operating in opposing directions if you think about the credit crunch that's of course an immensely deflationary event in the markets and in response to that governments have an ultra loose monetary policy interest rates have come down to practically zero in an awful lot of economies and we have negative interest rates in some places and we have quantitative easing consequence of that of course is that you have a potential for deflation from the initial driving force the credit crunch and a potential for a lot of inflation from the policies that have been put in place to counter the impact of the credit crunch and the question is which one of those two forces is going to be in the ascendant and that's where our index-linked bonds and perhaps more importantly our derivatives come into play giving fund managers banks pension funds the ability to remove the risk inflation is determined by the overall activity in any given economy it's not something that just is subject to the fluctuations of market supply and demand so when you're trading and inflation-linked product as opposed to an interest rate product then you're trading something with reference to an economic variable which is not affected by the actual process of trading that rate so inflation is a little bit different in that respect to other assets if you like the use of inflation products be they bonds or derivatives it is of course to transfer risk from one party that the group that's long inflation for example for example a government can issue index-linked bonds allowing the people who are very short inflation the people who suffer from inflation to borrow those bonds and thereby hedge their inflation risk derivatives of course provide a much wider range of techniques and solutions to different parties inflation exposures one other example of the use of inflation derivatives in the recent past has been by hedge funds who have been able to buy index-linked bonds which historically have traded quite cheap in relation to the rest of the market in relation to nominal bonds and by buying an index linked bond and doing an asset swap and then doing the reverse transaction with a nominal bond the hedge fund has actually been able to pick up quite a a good return from that structure well that the starting point really is your inflation once you've got that then you can use that to value and revalue a range of inflation derivative so we want to look at zero coupon inflation swaps then we build up an inflation curve based on the swaps market and we can compare that with the inflation curve that we get from index-linked bonds and the difference between the two which actually can be quite significant and it has been for some time in the united states gives rise to possible strategies that we can put in place in the interest rate world we can easily derive a forward interest rate from zero coupon rates in the inflation world that's not quite so easy because of course inflation is only known at the end of a given time period it's not known about at the beginning of that time period which means when you try and derive forward inflation from zero coupon inflation we have to introduce a and adjustment which is derived from the volatility of inflation and actually also the volatility of interest rates so if we're looking at derivatives we tend to build an inflation curve which is derived from derivative products and taking into account seasonality and then use that to revalue and manage the risk of our existing positions when we want to think about options on inflation then of course we need to look at our basic inflation curve and think about the impact of volatility in inflation on the price of inflation options and there are a number of different styles or varieties of inflation options that are starting to become more and more liquid in the market the LFS inflation course shows you how to use derivatives and index-linked bonds to hedge trade and manage risk in today's market exercises and spreadsheets help you apply what you have learnt as your career progresses well in the LFS program we look at a range of things we start off by building up an inflation curve from index-linked bonds so we take index-linked bonds and we produce innovation curve where we have zero coupon inflation which is inflation from a particular point in time to a specific point in time in the future rather than some sort of measure of break-even inflation involving yields this of course is a much more precise measure of inflation that's traded in the markets and it's an essential part really amusing doing anything either in index-linked bonds or with inflation derivatives we then go on to have a look at the swaps market and of course consider one of the big features of the inflation market which we don't have in the market for interest rates products which is a seasonality in inflation the issue with any program which is quite technical and quite in-depth and which involves a lot of some nuts and bolts or how to do it type of information is actually making the transition between the classroom and what goes on in the office and one of the things we do is have a look at index-linked bonds on asset swap so you can take an index linked bond and you can compare it with a nominal bond in terms of an asset swap so you can transform both bonds into a nominal floating rate note and you compare the spread overall under LIBOR that stems from doing an asset swap now of course in order to do that you've actually got a look at the cash flows and you could have work out what the asset swap levels aren't we course do that in one of the exercises then you've got to think a little bit about some of the sort of practicalities around doing an asset swap in other words the the credit risk that you take by asset swapping a high coupon bond versus a low coupon bond doing that that sort of aspect which isn't easy to capture in a spreadsheet has to be thought about as well we have a wide range of pension fund managers we have inflation traders we have middle office people who are in the process of analyzing the models being used for managing inflation risk we've had a lot of interest from central banks and government on government bodies a range of people from a number of different sorts of institutions local banks banks in other parts of Southeast Asia and also fund managers as well based in that region you,


inflation, derivatives, index-linked bonds, lfs, fixed income, hedging, risk management

Inflation Linked Funds

Inflation Linked Funds



If you want to buy bonds which have built-in inflation protection you have a couple of choices I have you by the individual bonds directly or you can buy a pool of the bonds wrapped up inside a fund each of the two methods has its drawbacks and benefits so here we look at some of those practicalities in detail bear in mind all of these examples are just illustrative if you want to investment advice go and see your independent financial advisor in our inflation video we look to see which of the asset classes provide some degree of protection against rising inflation bonds don't because their income is fixed an inflation is the mortal enemy of bonds gold was simply not reliable its historic returns just aren't linked to inflation shares provide a bit of protection but once inflation reaches about full percent all of that protection disappears the only asset class where there's a reliable link between its returns and inflation is inflation linked bonds I use an application called share scope to look at share prices and bond prices I've done a simple search for index-linked Treasuries here's a list of 28 of them if you want to search for these on your broker's website you can use these codes on the Left I've highlighted Road 14 and the identify there is trt q the bond was born or issued in 2011 and it dies or matures in 2034 and the price is about a hundred and forty eight pounds so I went to my broker's website in this case Barclays I look up TR T Q and the buy price is a hundred and forty-nine I click on deal and oops I get a message saying this stock cannot be traded online please phone us to place an order so these are the two problems the trading sizes are big well if I couldn't afford a hundred fifty pounds share prices tend to be much smaller the second problem is that for small investors such as myself index-linked bonds are harder to trade they're less liquid than shares liquidity remember is how quickly you can buy and sell an asset if I had millions of pounds to invest inflation linked bonds would be very liquid but not for the little guy this is why we might want to think about an alternative which is an inflation linked fund a fund is just a managed pool of investments that can be actively managed we're a highly skilled fund manager selects individual assets to buy and sell but what we consider here a passive funds which tend to be cheaper funds are great because they provide access to a wide range of markets these can be shares bonds commodities or a whole pool of assets mixed up together good multi-asset funds the second benefit which is very pertinent here is liquidity funds traded quickly easily and cheaply because we're buying a pool of asset we get a degree of diversification but in this case that's not particularly relevant buying a very liquid fund can also reduce costs we're also buying the expertise of the fund manager funds come in many flavors here we're going to consider exchange-traded funds remember this is just illustrative and not expressing a preference for one type of fund over another in the UK your choices are fairly limited there are three main inflation linked exchange-traded funds they called exchange-traded because you buy and sell them just like a stock which means that while markets are open you just look up the ticker which I've shown here in red i NX g g IL i and x g IG and then you just click on buy or sell just as if it was a single stock phi NX g and g ili are both linked to UK gilts the third one is a global pool of inflation linked bonds not just from the UK but also from the US and europe whenever you buy a fund it's always worth looking at the total expense ratio or te r if you buy a hundred pounds worth of i NX g the expense ratio is percent which means that you'd pay 25 pence a year to the fund manager which is Blackrock G IL I only has an expense ratio of 0.7% so you'd only pay them 7 pence a year on your hundred pound investment we can look at the fact sheet again purely for illustrative purposes in this case we'll look at INX G you can download a description of the fund from the iShares website for example we can see that it passively cracks the Bloomberg Barclays UK government inflation linked bond index well that's good because we want to track index-linked bonds the ongoing expenses are just point two five percent of the capital invested income has paid to you two times per year and it's reassuring to see that the size of the fund is considerable it's almost a billion pounds and of course is popular for a reason we can also see the top holdings in the bottom right in other words of the bonds in which that 1 billion pounds is invested in the bottom left you can see how closely the fund has managed to track its benchmark usually it's within point 1 percent each year ideally we'd run that tracking error to be 0 to show the benefits of inflation protection we can take two very similar funds the fund manager is the same Blackrock both are based on UK government bonds but the one on the left is not linked to inflation the one on the right I on X G as we've seen is linked to inflation the colored boxes represent which risks we're taking with each of the two different funds I've shown four of the risks here and because the contents of the funds are so similar they share three of those risks but the difference between the two is the inflation risk risk and return are related so very roughly we could say that the only difference between the returns should be compensation for taking UK inflation risk let's see how much that pays this would be the value of 1000 pounds invested in 2007 the red line is the inflation linked fund the blue line is the gilt fund which is not inflation linked in the panel below I've shown the level of inflation you're on yeah for the UK hopefully what you can see is that when inflation is high such as in 2009 and again around 2012 the red line starts to move up above the blue line as the inflation protection pushes up the values of those index-linked bonds conversely when inflation is very low such as in 2015 gilts will outperform of course what's really interesting is that most recently in 2016 we've started to see those inflationary pressures rise again and as a result the index-linked fund has outperformed again it always pays to look at the risks on the cheat a key one here is that if we get deflation there's no protection of your principle in other words if inflation goes into reverse and you get deflation where the prices of goods and services is falling then you can make a capital loss on your linkers and on your fund and also in the small print you can see that the credit rating of the UK may adversely affect the price of the fund but surely the UK would never get downgraded well actually yes it could this was a story in the FT as recently as January the 18th talking about the effect of brexit uncertainty on the credit rating of the UK and this is seen as a very material risk by many of the rating agencies so this is something which you should be aware of and finally a reiteration of the legal bit this is not a recommendation but if you found this interesting you could seek independent financial advice and I'm sure your IFA would love to discuss this with you in more detail.



inflation-linked bond, inflation linked bonds, inflation linked bond, inflation linked bonds explained, inflation, alternative inflation protection, investment, investing, ETF, how to protect against inflation, inflation-indexed bond, fixed income, INXG, XGIG, GILI, inflation etf, bond