Duration Model in periods of rising inflation

Transcription

1 ROCK note July 2011 Duration Model in periods of rising inflation For professional investors only Johan Duyvesteyn Quantitative Research Martin Martens Quantitative Research Olaf Penninga Fund Manager Robeco Flex-o-rente and Robeco Lux-o-rente Introduction Inflation is on the rise and bond investors fear further inflation increases. Active duration management is required to protect fixed income portfolios against the adverse impact of higher inflation. In this note we extend the backtest of the duration model to study its performance in times of rising inflation. The duration model has predicted bond returns successfully during such periods. Robeco s quant duration strategy is hence well-suited to navigate bond portfolios through periods with high or rising inflation. Robeco has applied its quantitative duration model in practice since the nineties. The backtest of the model started in the eighties. Both the live period and the backtest period have been periods with generally declining inflation and falling bond yields. As inflation has started to rise and expectations are for a further rise, we wanted to study the model during times of high and rising inflation. To do so we had to extend the backtest. US interest rates have been trending lower for nearly 30 years. Commonly cited reasons have been the disinflationary influence of cheap labor and goods from globalization and reduced inflation risk as the Fed gained credibility as an inflation fighter. As a consequence bond returns have been great during this period, providing both coupons and capital gains. Yet going forward it seems that the aforementioned reasons might change direction to cause higher inflation. Emerging markets are now an inflationary source of demand for consumer goods and commodities; and the Fed has provided unprecedented amounts of liquidity to stimulate growth and employment. For these reasons we decided to investigate the US bond market prior to the September peak in interest rates. During the seventies and early eighties inflation reached very high levels. This resulted in negative bond returns relative to cash. Hence we had a bear market rather than a bull market. More specifically we find government bonds to perform poorly relatively to cash both in periods of high and of rising inflation. To extend the backtest we have created a reasonable proxy for the model for the US that goes back to. We find that the duration model performs well during the bear market prior to. And we also show that the model generally does well both in high inflation periods and in periods of rising inflation. The duration model has proven its value in practice in a period of generally declining inflation, but our research shows that the quant duration strategy can also protect fixed income portfolios in times of high or rising inflation. Page 1 of 6

2 Inflation and US government bond returns In the US we have sufficient historical bond market data to extend the backtest to a period with higher inflation. We use Ibbotson data for bond returns and cash returns (1-month T-bills). The cumulative excess returns and the bond yield are shown in Figure 1. Bonds showed a remarkable performance in the past 30 years, starting at the peak in yields in September. The graph also shows that bond investors suffered large losses from July onwards in the run up to these high yields. We will see below that this period coincided with a sharp increase in inflation. Figure 1: Cumulative excess bond returns and the 5-year yield 8 6 5y Government bond cumulative excess return 5y Government bond yield Cumulative returns Figure 2 shows the US Year-on-Year (YoY) inflation measured by the Consumer Price Index (CPI). The graph shows that the US experienced periods of very high inflation in the seventies and early eighties. That makes this period interesting for bond investors. How do government bonds perform in such a period? year yield Figure 2: Year-on-Year inflation (US CPI) 16% 14% high inflation % 1 8% rising inflation % 4% 2% -2% -4% Page 2 of 6

3 We encircled in Figure 2 the period of high inflation in the 70s and early 80s. For this period we compute the excess returns of 5Y bonds over the 1-month T-bill rate. In addition we show excess bond returns in the months where inflation rises most. For this we use the shaded areas in Figure 2, which cover about 3 of all months. The results are shown in Figure 3. It is clear that both high and rising inflation on average lead to government bonds underperforming relative to cash. During the high inflation period from July to November 1982 the cumulative excess bond return amounted to 8.4%. Figure 3: Excess US bond returns (per annum) during high and rising inflation 1.5% % % % -2. High inflation Rising inflation Full history (-2010) So government bonds had a great bull run since Sept. But data before Sept reveal quite a different picture as government bond investors suffered from the spike in yields in reaction to rising inflation. This underlines the need for protection of bond portfolios against rising inflation and the resulting rise in yields. Inflation and the quant duration model We extend the backtest of the model only for the US for reasons of data availability. In practice we implement the model s signals in the US, Germany and Japan. Nevertheless, the extended backtest allows us to verify the performance of the main factors in the model in times of high or rising inflation. The model uses financial-market data to capture expectations for macro-economic drivers of bond markets like growth and inflation. Technical indicators like trend and valuation complement these factors. We focus on the model results in periods of high inflation and in periods of rising inflation. Here we use the same categorization as in Figure 2. First we focus on the high inflation period. Figure 4 shows that the model performed very well in the high inflation period from The buy and hold bond portfolio suffered negative excess returns in this period, but this could have been compensated by the quantitative duration strategy. Page 3 of 6

4 Figure 4: Cumulative excess returns during periods of high inflation 15 Inflation (YoY) is very high Cumulative performance Duration Model Cumulative performance 5y bonds More generally speaking, the model has a good performance from to, when bonds did worse than cash, as well as over the original backtest period. Hence the model performs well in bear markets as well as in bull markets. Figure 5: Cumulative excess returns during periods of rising inflation Inflation (YoY) rises most Cumulative performance Duration Model Cumulative performance 5y govt bonds Next we look at periods of rising inflation. Here we use the seven periods of rising inflation identified in Figure 2. These are marked as the grey areas in Figure 5. The graph shows that the model generally has a good performance during rising inflation periods. This is in marked contrast with the buy and hold portfolio of 5-year bonds which generally has a poor performance during such periods. Hence the duration model used as an overlay on a government bond portfolio would provide protection against rising inflation Page 4 of 6

5 Conclusions In this memo we investigate the performance of the duration model in times of high and rising inflation. We have extended the backtest of the model back to to add a period with higher inflation to the usual backtest. Some important conclusions can be drawn from the analysis. Good performance of the model when inflation is high The model is working very well when inflation is high. Hence if going forward we enter a period of high inflation we are confident that the model can do well. The model offers bond investors protection against rising inflation Government bonds perform poorly not only when inflation is high, but also when inflation is rising. In contrast we find that the model has a good performance when inflation is rising. Hence the model can provide protection for bond investors when used as an overlay on the bond portfolio. Model successful in both bull and bear markets We studied US bond data prior to the peak in interest rates in September. In fact cash outperformed bonds in the - period. We find that the model is doing well during this bear market period. This makes us confident that after the 30- year bull market the model can continue to do well when going forward we would have a (possibly inflation-driven) bear market. Page 5 of 6

6 Important information This document has been carefully prepared by Robeco Institutional Asset Management B.V. (Robeco). It is intended to provide the reader with information on Robeco s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. Any investment is always subject to risk. Investment decisions should therefore only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. The content of this document is based upon sources of information believed to be reliable, but no warranty or declaration, either explicit or implicit, is given as to their accuracy or completeness. The manuscript has been closed on the abovementioned date. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation. The information contained in this document is solely intended for professional investors under the Dutch Act on the Financial Supervision (Wet financieel toezicht) or persons who are authorized to receive such information under any other applicable laws. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco s expectations for the future. Past performances may not be representative for future results and actual returns may differ significantly from expectations expressed in this document. The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future. All copyrights, patents and other property in the information contained in this document are held by Robeco Institutional Asset Management B.V. No rights whatsoever are licensed or assigned or shall otherwise pass to persons accessing this information. The information contained in this publication is not intended for users from other countries, such as US citizens and residents, where the offering of foreign financial services is not permitted, or where Robeco's services are not available. Robeco Institutional Asset Management B.V., Rotterdam (Trade Register no ) and Robeco Securities Lending B.V. are registered with the Netherlands Authority for the Financial Markets in Amsterdam. Page 6 of 6