Robert Hayes explains the ways pension funds can hedge against inflation
Former US president Ronald Reagan once observed that inflation is “as violent as a mugger, as frightening as an armed robber and as deadly as a hit man”. Little wonder that most investors would flee town in the dead of night to avoid it. But while the majority of institutions have clearly identified inflation as a significant area of concern, not all have formed clear strategies to cope with it.
Not everybody subscribes to the view that inflation is an immediate threat to the global economy. Many commentators argue that there is sufficient slack in the systems of most developed world economies to keep significant inflation at bay. However, justified or not, there is no doubt that inflation currently ranks high on institutional investors’ list of concerns, and any organisation that is seriously worried about inflation is likely to be trying to hedge against it.
What inflation risks are you running?
Before attempting to hedge against inflation, it is important to establish what inflation risks you are running. The answer to this question is rarely simple and will be determined to a large extent by the country in which you operate. In the Netherlands, for example, the system of discretionary indexation means that the level of pensions’ inflation hedging is dependent on a wide range of factors, including the financial strength of the scheme, the relationship with the sponsor(s), the scope for intergenerational risk sharing and the attitude of the trustees.
In the UK, by contrast, most organisations have a complex mix of fixed and inflation-linked contractual and regulatory obligations, with caps of between 2.5 per cent and five per cent. A few funds may have higher caps for certain employees and some trustees may wish to be more generous than the contractual minimum in the event of higher inflation; if they have the resources and support of the sponsor.
The hedging dilemma
Institutional investors face a number of inflation hedging choices, the most simple of which is cash. As cash rates are expected to rise with inflation, they should theoretically provide a hedge against it. However, the extent to which cash can hedge against inflation is heavily influenced by the monetary policy regime of the relevant currency’s central bank. At present, many central banks are maintaining low cash rates as they attempt to nourish their respective economies back to health in the wake of the 2008 financial crisis. Clearly, in such circumstances cash is no hedge against inflation.
Equities are generally considered to be a good inflation hedge over the long term, although they are subject to periods of volatility and underperformance. The major disadvantage with equities is that they tend to suffer in periods when inflation is rising. As inflation increases, earnings also increase, but usually by a smaller fraction than the rise in inflation, which erodes companies’ purchasing power. However, when inflation abates again, prices do not fall as quickly, enabling those companies to recoup their earlier loss of purchasing power. In the 1970s, for example, stock prices did not rise as fast as inflation, but from the early 1980s onwards they began to rise steadily, more than offsetting the earlier loss of purchasing power.
The lesson is that inflation-hedging with stocks is possible but not easy. Research has shown that the best protection comes from companies that can set their own returns at levels that beat inflation – but shares in such industry leaders do not tend to come cheap.
A major influence on how institutional investors attempt to hedge inflation is whether they are more concerned with short-term or long-term inflation. If a pension fund is highly concerned about year-on-year measures of solvency, then it will need duration, or sensitivity to inflation expectations linked to the present value measure of liabilities. If the company is more concerned with the long-term value of its assets, it will need inflation sensitivity that adjusts the value of its assets over time as recorded inflation changes. In the former case, index-linked securities are the most likely answer; in the latter, it is likely to be real assets that are sensitive to modest changes in inflation.
Index-linked securities carry an inflation expectation built into their price, which is the difference between the price of the nominal bond and the price of the inflation-linked bond, often referred to as the breakeven rate. Index-linked securities can be used to construct a portfolio to effectively hedge
long-term inflation risk. However, there are a number of factors to consider before using them.
One is that the breakeven rate is imprecise and can be distorted. This is largely because it fails to consider a strategic inflation risk premium – i.e. the mark-up on the nominal bond yield that investors demand as compensation for shouldering the inflation risk that an index-linked bondholder does not. This means that the breakeven rate represents an inflation risk premium as well as an expectation of inflation.
Another factor to consider with inflation-linked securities is that there are a large number of very different measures of inflation, and very few traded instruments that reflect the types of inflation that are relevant to most investors.
Real assets, real cash flows?
Pension funds with a longer-term perspective on hedging against inflation are increasingly attracted to the real cash flows offered by real assets to offset the effects of inflation. Examples of real assets include property, commodities, gold, infrastructure or funds which combine some or all of these.
Property values tend to rise in inflationary cycles, leading to higher real cash flows. In particular, rental income shows a strong link to inflation. But values tend to increase most late in an inflationary cycle, indicating that property lacks sufficient short-term sensitivity needed for a real hedge. Also, if inflation persists and affects economic growth, property investments can suffer in the long term.
Commodities will stand up under certain inflationary pressures and will prove to be a good investment as developed world demand continues to push prices up. But, like property values, commodities are linked to year-on-year inflation and bear little sensitivity to long-term breakeven rates. Investors also need to be aware of the potentially significant differences in returns between spot prices and futures prices – most institutional investment products tend to be futures-based.
Gold is a traditional safe haven when currency is deflating and, at a time when many governments are deflating currency to maintain economic competitiveness, gold appears to be a prudent investment. Prices appear very high at present, but this probably reflects depressed currency valuations rather than high gold valuations.
In theory, infrastructure presents a good inflation hedge as underlying investments are linked to contracts with implied inflation protection. However, in practice infrastructure investments can be illiquid, complex and contain significant property development risks. They can also involve high levels of leverage, which may not be inflation hedged, making them less than ideal as inflation hedging instruments.
Three questions you need to ask
When considering how to hedge against inflation, investors need to ask themselves three questions. First, what level of risk am I willing to take? Second, what is the basis risk of any hedge that I take (i.e. what is the possibility that the hedging instruments are not tied to the inflation measure that matters most to me, adding risk to my position)? And finally, what reward do I stand to gain for taking the risk – or what return will I give up for ‘buying’ the hedge?
There is no foolproof way of hedging against inflation, but the chances of dealing with any infla-tionary challenges that lie ahead can be increased dramatically by successfully answering these questions.
Written by Robert Hayes, head of Client Strategy for EMEA-Pacific within the BlackRock Multi-Asset Client Solutions (BMACS) group
Robert Hayes explains the ways pension funds can hedge against inflation