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.
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Cavanaugh (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.