Guarding Against Inflation With CPI Swaps Instead of TIPS

Portfolio strategy captures the difference between expected and actual inflation without exposing investors to changes in real interest rates, says J.P. Morgan’s Cavanaugh

Advisors worried about inflation risk may prefer protecting portfolios with CPI swaps rather than Treasury Inflation-Protected Securities (TIPS), says J.P. Morgan Asset Management’s Jim Cavanaugh in a recent client research note.

CPI swaps, a derivative pegged to the consumer price index, offer a more efficient hedge relative to TIPS because they are a higher-yielding and shorter-duration alternative, and they don’t have the real interest rate exposure that exists in a typical institutionally managed TIPS portfolio with durations of approximately five to eight years, Cavanaugh wrote in the note.

“CPI swaps offer pure inflation exposure, effectively isolating inflation risk from real interest rate,” Cavanaugh wrote. “CPI swaps provide investors a higher correlation to inflation, due to the direct exposure to CPI inflation.”

To address what it considers as risky all-TIPS strategies, J.P. Morgan Asset Management has developed an alternative inflation-protected investment strategy. The Inflation Managed Bond Fund (JIMAX) combines short- to intermediate-term investment-grade fixed income securities with CPI swaps, and it may also buy other investments including TIPS.

Jim Cavanaugh, J.P. Morgan Asset ManagementCavanaugh (left), a client portfolio manager in the U.S. Fixed Income Group at J.P. Morgan Asset Management, acknowledged that rampant inflation is not yet in the offing, but he said that due to their exposure to real interest rates, TIPs returns and actual inflation rates have a correlation of only .30.

On Thursday, the Bureau of Labor Statistics reported that CPI, the government’s key inflation measure, was unchanged in January for the second month in a row. However, economists expect both food and gasoline prices to rise in coming months, and prices are now 1.6% higher than they were a year ago.

According to a PIMCO note on inflation-linked bonds, inflation has been low for many years around the world, and U.S. inflation from 2001 through 2011 has averaged 2.5% annually, based on year-over-year changes in the CPI. But even at this relatively low annual rate, inflation diminishes purchasing power, so that goods and services that cost $100 a decade ago would cost $128 today, according to the note.

“While rates can certainly drop lower in the near term, they cannot be expected to stay at these low levels forever,” Cavanaugh wrote. “An increase in real interest rates decreases the effectiveness of TIPS as an inflation hedge. It will be important for investors to understand that there are a number of ways, other than purchasing TIPS, they can protect their portfolios and generate attractive returns in a rising inflation and interest rate environment.”

Read PIMCO’s Bill Gross QE4 Warning: Here Be Inflationary Dragons at AdvisorOne.

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