Thursday 09 May 2013 by FIIG Research Legacy

Choose your “bubble” wisely

Please note that the figures mentioned in this article are no longer available.


While recent European data is crumbling as you read this, and China is fast slowing, we all hope that the US will carry the global economy. Such a hope is sustained by quantitative easing (QE) in most developed markets but, a warning; QE has created “bubbles” in all markets. While QE is forcing rates lower, it is forcing market participants into any equity that vaguely resembles a bond (via “known” dividend yields), to the degree that equity markets can now be seen to be very much in “bubble” territory. Here, this “bubble” has divorced equity pricing from the “fundamentals” of very meagre economic developed world growth, on the hope that QE will save everyone all the time, among other things.

Sure, QE has elevated bond prices and depressed yields, yet the influence on equities is bigger, stronger, and potentially much more dangerous for investors. Hence, the question for investors is not whether there is a “bubble” in bonds, but which “bubble” provides the best risk and return trade-off, and what is world “best practice” with regard to portfolio design. A better portfolio design relative to global best practice, typically means, in the case of Australia, more bonds and less equities, since Australians are typically overweight equities relative to other developed markets, and underweight bonds.

In this heady environment it is important to stand away from the euphoria and look at what investors are trying to achieve with superannuation savings. Here, we argue that the basic problem for investors is to ensure that inflation does not intervene, between the point of saving while working, on the one hand and spending in retirement, on the other hand.

Specifically, we argue that inflation has, is, and always will, feature in the selection of investment strategies for all investors. We argue that inflation linked bonds trump other assets and come up the best product to protect against inflation, from several perspectives and explain these arguments in the following three parts:

  1. Best we have: the CPI remains the best tool that we have to gauge the purchasing power of deferred spending and the procedure of matching assets with liabilities needs careful consideration,
  2. Best correlation: other assets pretend to provide insurance against a rise in the CPI,
  3. Best to act fast: as bonds are becoming more and more attractive as nominal cash rates move lower and stay lower for longer.

1. Best measure of purchasing power

Saving is the procedure of deferring spending, and the value of that deferment is best gauged by the CPI. If you think about your retirement in terms of an inflation linked liability, then the value of ILBs, as an asset, become manifest. Specifically, in contrast to building your savings, which actuaries refer to as “accumulation”, retirement is all about spending, or what the actuaries call “de-cumulation”. Spending, during retirement, is all about having adequate investments to achieve adequate purchasing power. If the time, between saving and spending is long, which it typically is, then the influence of inflation on spending power is not only very large, it can effectively “make” or “break” your investment strategy.

Global pension fund managers take the idea of a pension cashflow, as an inflation linked liability very seriously, where the procedure is called “liability driven investing”, or “LDI”. Here, the “asset”, or the pension asset cashflow, is selected relative to the underlying “liability”, or series of expenditures, which typically remain linked to the CPI. Several steps are involved in implementing the “LDI” strategy, as follows:

  1. Estimate liabilities: For an individual to follow the LDI strategy, the individual needs to estimate the spending required each year of their forthcoming retirement period, after assumptions regarding social security payments. This stream of spending, or expenditure, can be thought of as a stream of “liabilities”, which typically rises with inflation.
  2. Select assets to match liabilities: Given that the liability stream is now known, assets should be purchased to match that stream of inflation linked liabilities. This would typically mean purchasing a series of ILBs, and shorter dated bonds.
  3. Invest balance of funds in “growth”: If there is a surplus, then these funds should be carefully invested in so-called “growth” assets, like equities, commodities, gold, and housing.

This is not a procedure “dreamed up” by FIIG, but is a very important part of institutional investing worldwide and should not be ignored, as it makes a lot of commonsense. For example, in the UK, companies now have to advise of the funding position in their pension funds, as part of the company balance sheet, and similarly in the US. Moreover, if major corporations need to report funding shortfalls, where liabilities are greater than assets, on the balance sheet, then one wonders why more Australians do not think about the strategy of their investments in a similar way; the need to report shortfalls brings problems out of the dark and help focus attention on the important issues.

Instead of buying “growth” assets and simply “hoping” that everything goes well, as seems to be the complacent attitude of most Australian super finds, this approach is much more measured and conservative. Specifically, before you buy anything, you need to know your liability stream, and that can be estimated from monthly expenditure levels; it is not that hard to define. Longevity is also important, so plan for a longer life; not shorter.

Yes, there is room for “growth”, yet the room is measurable, and the risks are known; risk of underfunding your own retirement quickly becomes apparent.

Given the recent equity market outperformance, now would be a good time to rebalance your portfolio using the LDI approach. ILBs are the key to implementation of LDI in your portfolio, since they provide the inflation insurance that can, if left uninsured, increase your retirement shortfall, where your liabilities outweigh your assets.

2. Best insurance against inflation is an ILB

Other asset classes have all tried, through their various promoters, to masquerade as inflation hedges, and you will hear the term “great inflation hedge” offered for a variety of asset classes, especially equities. However, little attention is paid to the time period referred to in these statements, and evidence, as shown below, supports the case that most asset classes remain quite poor hedges, against inflation. Figure 1 shows relative correlation per asset class to the CPI and commences at the start of the respective indices, so time periods differ. The asset classes include:

  • AUD equities, using the All Ordinaries Accumulation Index,
  • Gold, using the gold price,
  • Median house prices, from RP Data,
  • Commodities, using the CRB Index, and
  • Credit ILBs, using the UBS credit ILB index 0+years.

Notice how all asset classes are very volatile, relative to the CPI, as shown on the horizontal axis, while the return, relative to the CPI varies substantially. The risk and return of the asset classes are evaluated relative to the Australian inflation rate. While equities have good return characteristics, relative to ILBs, they add much more risk, relative to the CPI, over 15%, when compared to ILBs, while the return above inflation is around 8%. In other words, the risk of equities, relative to inflation is higher than the return of equities, relative to inflation.

Credit ILBs, on the other hand, have much lower risk to inflation, and returns on offer are currently around 4% above inflation; a little higher than shown above. Credit ILBs, like other assets, have mark-to-market variations. If we take full account of these variations, then we have can compute a volatility measure to the CPI as noted as point “B” above. In contrast, if we ignore mark-to-market volatility, the volatility to the CPI approaches zero, or point “A” in the above. We would argue that point “A” is much more relevant to investors, when compared to point “B”, and that most investors would see their volatility as being somewhere between point “A” and point “B”, as shown above.

In particular, the correlation of AUD annual inflation and annual AUD equity total returns is poor, to say the very least, on a rolling 5 year basis, as Figure 2 indicates.

Ok, you will “make money” out of equities, if you hold them for the long term, while you also know that you will “make money” out of a corporate ILBs. However, by investing in corporate ILBs, you will also know the following:

  • exactly what rate above inflation that you make, which is roughly the same as the return on equities in the US from 1950,
  • you have insured against inflation,
  • your volatility of return, relative to inflation is low,
  • you will not be caught out with a supposedly “stable” share that pays a high dividend yield, as BHP appeared to provide in 2011, at a price of near $50, now at $34,
  • in a crisis situation, you are in a senior position and your investment will have a recovery value much higher than equity

3. Best time to act is before the rush

Low nominal rate bonds (fixed rate US Treasuries and Australian Commonwealth bonds) are not part really of a “bubble”; rather they remain effectively the policy instrument that central banks use to stimulate economic growth, as the cheaper the funding for corporate borrowers, the more they will borrow, all else being equal. Making it easier for corporations to borrow assists the corporate to increase employment, and all the benefits that pertain to such increases in employment, including broad economic growth.

Quantitative easing in the US has, is, and will continue to, compress nominal rates to the rate of inflation, as Figure 3 illustrates. The graph shows estimates of the US 10 year corporate yield by adding 100bps to the US swap rate.

If you thought that US inflation linked bonds were expensive, at 55bps less than the rate of inflation, then so are the nominal government bonds, with a nominal return at around 1.75%. Investors are that nervous about inflation, they are willing to accept a negative real yield. In general, all bonds tend to trade at low yields in a low yield, quantitative easing environment, as the investor return is effectively hijacked by the US government, or the central government in the country undertaking QE, for the benefit of the greater good. We anticipate that QE will remain in place in the US for longer than the market expects, which is 2015; somewhere around 2016 or later. In other words, this procedure of spread contraction, between the nominal bond and the ILB will continue for some time, and will, other things being equal, intensify.

While Australia faces a different situation, where QE is not in effect, the impact on Australia cannot be ignored, and the recent fall in the yield of corporate ILBs has been testament to the ongoing spread contraction in all markets; from nominal to the ILB market.


Opportunities for protection against inflation come and go, and the recent opportunities in the Australian inflation market are fast “going”. Low cash rates for longer will mean that the Australian market follows the trend, towards lower yield, that is now entrenched in other developed markets. Apart from other things, this means that Australia will look more and more like other developed countries, not less, over the next few years. Compression of spreads to inflation is now the order of the day, and will remain the order of the day. Here, the relentless compression of spread will begin to impact the procedure of matching assets to liabilities, as suggested in part two above. Specifically, it is much easier to do when real rates are high, compared to when yields are low.

While other asset classes masquerade as inflation hedges, the facts do not support this charade; the rouse is well and truly up, if you refer to the facts, covered in section two above. Choosing which market, or which “bubble”, is the best for your portfolio, remains more crucial today that it has been in many years. Portfolio allocation within the context of the LDI approach suggested herein, is even more important. Using LDI, as the basis for portfolio allocation, provides a sensible framework for retirement planning.