Liability Hedging Assets

On this page we seek to cover in debt the the suitability of individual asset classes in a liability hedging portfolio, dependent on the different liability benchmarks. 

Alternative

- Liquid Real Estate (REITs)

An alternative to direct property investment is securitized real estate in the form of Real estate investment trusts (REITs). REITS are typically designed to capture the cash-flows of the underlying properties typically indexed to CPI, so their performance resembles that of real estate. Conclusion: REITS should at least partially hedge inflation, depending on the pass-through of price increases.

- Infrastructure

- Master Limited Partnerships

- Timber

Commodity

- Broad based commodity funds

Commodities are somewhat different from other securities. While equities and bonds are claims on future cash-flows, commodity futures are bets on the future expected spot price of commodities. This makes commodity futures more sensitive to current economic conditions than equities and bonds, which discount future states in perpetuity or in the case of bonds until maturity.

The total return from a fully collateralized commodity futures investment can be de-composed into tree sources:

1. Spot return: The gain or loss from changes in the underlying spot prices.

2. Collateral return: The return earned on the collateral that backs the futures.

3. Roll return: The return earned as the futures price converges with the spot price. It is the difference between the collateralized futures return and the physical spot return.

Changes in spot prices contribute considerably to the volatility of commodity futures returns but less to long-term real returns. The roll return is less volatile but a significant determinant of long-term average returns. If the term structure of futures prices is downward sloping (Backwardated), the futures contracts increase in value as they mature and the roll return is positive. Conversely, if the term structure is upward sloping (in Contango), the roll return is negative.

Some argued that commodity term structures are normally inverted because markets are dominated by producers wishing to hedge against falling prices. In this configuration, a positive risk premium (downward sloping term structure) is priced into commodity futures in order to attract speculative capital to take the other side of the trade. However, in a market dominated by consumers wanting to hedge against price increases, or where demand for long commodity exposure is high (perhaps from passive index investors), the risk premium should be earned by speculators taking short positions in commodity futures. The current extent of Contango across many commodity markets limits expected real returns from investing in commodity futures.

There are four mechanisms by which commodities can hedge inflation:

1. Direct link. Commodities and broad inflation are directly linked. Commodities are production inputs, hence any increase in commodity prices that is passed through to prices of final goods affects the measure of inflation.

2. Temporary increase in demand. An increase in the money supply leads to a temporary increase in aggregate demand. Higher demand for finished goods increases the demand for commodity inputs. While these inflationary shocks are positive for commodity spot prices in the short run, they do not stimulate long-term increases in demand. Hence, spot prices will likely increase over short horizons but gradually decrease over a longer horizon.

3. Self-fulfilling prophecy. Because commodity prices are sensitive to inflation pressures, investors view them as an attractive inflation hedge. To the extent that this remains true, investor demand for commodities will also increase as inflationary pressures rise.

4. Exchange rate effects. Commodities are mainly traded in US dollars. A positive inflation shock in the US that causes the dollar to weaken against other currencies will stimulate commodity demand among consumers outside the US in whose currencies their price has decreased.

Conclusion: Commodities are effective hedges against changes in inflation but during broad based Contango across asset groups, may post limited real return.

- Gold

Most commodities are produced for consumption, whereas gold is produced and then accumulated. Current inventories overwhelm production, and industrial uses are dwarfed by passive storage. These characteristics make gold (and precious metals more generally) fundamentally different from other commodities. Gold has value because it possesses unique properties that make it a convenient store of wealth. And because it acts like an ultimate reserve currency, its valuation is often driven by economic uncertainty and fear.

Warren Buffett put this more bluntly, during a speech at Harvard University in 1998: “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

For commodities we identified four reasons why they can serve as good inflation hedge. Some of these do not apply to gold. In particular, there is no direct link between gold prices and inflation. Gold is not a major production input, and gold purchases do not constitute a significant part of consumer spending. Likewise, a temporary increase in demand for goods will likely have a small direct impact on demand for gold, compared with demand for more industrially important commodities such as copper and oil. The mechanisms that link gold and inflation are three in number:

1. Self-fulfilling prophecy. It is widely believed that gold acts as an inflation hedge. To the extent that this remains true, investor demand for gold will increase as inflationary pressures rise.

2. Exchange rate effects. Gold is traded in US dollars.
A positive inflation shock in the US that causes the dollar to weaken against other currencies will stimulate demand among consumers outside the US in whose currencies gold appears cheaper.

3. Confidence in fiat currencies. Gold is considered a store of value. As such, it provides an effective hedge against spikes in the global economic system and monetary policy. Any increase, or expected increase, in global inflation that weakens confidence in paper currency will spur demand for gold and result in higher gold prices. This gives gold status as an ultimate reserve currency.

Conclusion: Gold is an attractive investment as a hedge against economic and currency collapse and against reduced confidence in monetary policy. However, it is a much less effective inflation hedge than a broad commodity investment and is unlikely to earn positive real returns over long time horizons.

Palladium & Platinum

No research so far, but one would presume the same Driver as Gold, except these has production utility.

Equities

- Equities in general

Financial theory tells us that the value of a financial asset
is the sum of the discounted expected future cash-flows. Equities ability to hedge inflation is dependent on the impact that inflation has on the discount rate applied to future cash-flows, compared with the impact inflation has on the earnings stream. In other words, the impact of inflation on equities depends on the key ability to pass input and wage inflation through in final goods prices.

If the nominal discount rate increases by the expected inflation rate, as suggested by the Fisher Effect, and the growth rate in earnings also increases with inflation (which implies that final goods prices move to fully reflect changes in inflation), then the value of the equity is left unchanged by inflation. If, however, discount rates change immediately to reflect changes in inflation expectations but final goods prices are sticky and fail to pass through inflation completely or immediately, then equity prices should fall as inflation expectations increase. Competition is likely a key force in keeping prices sticky as inflation expectations rise. Over time, however, inflation-induced increases in input costs are likely to be passed through in final goods prices. In some circumstances, it may be possible to pass through more than the impact of inflation. In these “pass-through-plus” cases, equities benefit from inflation surprises.

Assuming incomplete pass-through, equities should generate less real return during periods of rising inflation and more real return during periods of falling inflation than they would in the absence of inflation. This effect is weakest where the pass-through of inflation should be greatest, which is where competition is weakest. The net effect over an inflationary cycle is that inflation should be somewhat damaging to equities, with the fall in real equity returns as inflation picks up exceeding the recovery in real returns to equities as inflation cools.

Conclusion: If the pass- through of price increases is only partial or is lagged, then the discounted value of real cash-flows falls during periods of rising, unanticipated inflation; the discounted value rises during periods of unanticipated easing in inflation. But unless the pass-through of inflation is nonexistent, equities provide some degree of inflation hedge, and that degree increases with pass-through.

- Sector specific Equities

The state of Competition is a key factor for determining the pass-through of inflation The ability to pass inflation on to final goods prices falls as competition in the final goods market increases.

Basic Materials

Utilities

Conclusion: Depending on the ability to pass-through inflation shocks equities can serve as a valid inflation hedge.

Fixed Income

- Nominal bonds (Treasury)

Nominal government bonds have coupon and principal payments that are predetermined and do not adjust for inflation or deflation. If held to maturity, they offer a fixed nominal rate of return approximately equal to the starting yield to maturity. Hence the real Nominal bond returns are the subsequent rate of inflation relative to the yield, and changes in the yield. If current bond yields are higher than future inflation, they will offer returns above inflation when held to maturity; if yields are lower than future inflation, returns will be below inflation. Changes in nominal yields may create volatile returns on the path to that realized yield to maturity. Yield increases require prices to fall and therefore realized returns decrease. However, from that point on, expected future nominal returns will be higher. If yields fall, the opposite effects occur. Conclusion: Nominal bonds do not hedge inflation.

- TIPS

TIPS are US government bonds whose principal value is adjusted by the US consumer price index (CPI). For example, if the CPI increases by 1%, $1,000 invested in TIPS would adjust to $1,010, two months after the CPI reference month. Because the coupon rate is multiplied by an inflation-linked principal, TIPS have inflation-linked coupon payments. Also, at maturity, they pay the larger of the adjusted principal or the original principal amount, which provides some level of protection against deflation (although the coupon payments remain exposed).

The CPI adjustments to the principal mean that they hedge against recent (two-month-old) inflation, as defined by the CPI. However, changes in the market price for TIPS (which show up as changes in the real yield to maturity) will cause returns to TIPS that do not track inflation each year. For example, TIPS could have a negative return over a given period, even with positive inflation (or vice versa). These market price changes can be driven by changes in expected future real interest rates and supply/demand imbalances in the TIPS market. The price effects of these drivers will be larger for TIPS with a longer time to maturity. Conclusion: if held to maturity, TIPS will provide a CPI inflation-hedged rate of return dependent on purchase price.

- Hybrids

 

Overall conclusion: Because the shares of REITs and commodity-related equities are both stocks, they can amplify (rather than diversify) existing equity risk in a portfolio. If the increase in equity risk is modest and also provides a distinct inflation hedging capability, it may be worth the additional equity risk. This tends to be the case with REITs, which are the only liquid proxy for real estate. Since housing represents over 40% of the U.S. Consumer Price Index (CPI) as of February 2010, investors concerned with inflation should look to establish a hedge against real estate inflation.

While equities of companies in commodity-related businesses (such as shares of mining companies, for example) can provide an inflation hedge, we feel the better hedge is through an investment in commodities directly. A direct allocation to commodities is preferable because it provides the inflation hedging exposure while eliminating the incremental equity risk. This can be efficiently accomplished through a strategy that tracks a roll enhanced broad index of commodity futures. TIPS are a good inflation hedge regardless of the driver of inflation, as long as that is concurrent with range-bound or decelerating real growth expectations. That’s because rising growth expectations tend to push real yields higher, which causes price losses on TIPS that can offset their inflation linkage and real yield. REITs may provide a hedge against inflation based on their ability to extract levered equity returns from another key inflation driver: real estate rents. In economic environments where lease rates increase over time, reflecting real estate inflation, REITs generate higher income, which can drive REIT prices higher. Thus, REITs can be effective as a hedge when inflation is driven by the real estate sector. REITs can also be attractive in economic environments that are attractive for equities in general, such as those characterized by range-bound inflation and steady GDP growth.

 

Allocation size? 
Another factor to consider when constructing a diversified real asset strategy is the size of the allocation to each of the complementary inflation hedges. The two most important issues are the level of overall volatility targeted for the strategy and the desired mix of exposure to the different types of inflation hedges provided by each real asset. Regarding volatility, the trade-off is straightforward. Too low a volatility target and the portfolio mix overwhelmingly skews toward TIPS. Investors would lose the diversified inflation hedging exposures of commodities and REITs, plus the total strategy wouldn’t have much diversification effect against core stocks and bonds, which tend to dominate portfolios. Too high a volatility target suffers from the opposite challenges. The portfolio mix would skew toward commodities and REITs at the expense of TIPS. Furthermore, while the higher volatility level would provide more inflation hedging “zig” to help diversify the “zag” of traditional investments, investors may view the investment as too risky on a stand-alone basis.

(NOTE: Consider a DCS strategy of TIPS Core and separate Satellites of sector equities and Roll enhanced broad commodity funds, let multiplier be a function of  characteristic of inflation)

 

Research:

Edhec Risk & Asset Management - Inflation-Hedging Properties of Real Assets and Implications for Asset-Liability Management Decisions 

Find that various alternative asset classes exhibit attractive inflation-driven liability hedging properties. For instance, investing in com- modities leads to very low shortfall probabilities at virtually all investment horizons. While investing in real estate leads to higher shortfall probabilities in the short and medium run, significantly lower probabilities are obtained in the very long run (>30 years). These results suggest that novel liability-hedging investment solutions, in- cluding commodities and real estate in addition to inflation-linked securities, can be designed so as to decrease the cost of inflation insurance for long-horizon investors. These solutions are shown to achieve satisfactory levels of inflation hedging over the long-term at a lower cost compared to a solution solely based on TIPS or inflation swaps. The increased expected return potential generated through the introduction of commodities and real estate in addition to TIPS in the LHP allows for a reduced global allocation to the PSP while meeting the global performance expectations, which in turn allows for better risk management properties. For example, in the case of a 20 years investment horizon, the introduction of 5% (respectively 10%) of alternatives (real estate and commodities) within the LHP is found to lead to a 19% (respectively, 39%) reduction in shortfall probability. The reduction in severe shortfall probability is even greater and reaches a spectacular 42% (respectively, 78%). Overall our results suggest that alternatives are very useful ingredients for institutional investors facing inflation-related liability constraints.