Why inflation matters today

Market Insights: October 17, 2016 • Inflation risk
 

“With an easing in global deflationary forces that can be attributed to the prospect of less fiscal austerity, global trends favouring protectionism vs. globalization, and increasing wage pressure due to full employment in the U.S., I’m confident we’ll see inflation closer to 2% in the next few years, versus 0 to 1%.”

— Clément Gignac, M.E.Sc
Portfolio Manager, Industrial Alliance Investment Management
Senior Vice-President and Chief Economist, iA Financial Group

“When you look at various consumer price indices (CPIs) and what’s impacting them, inflation at 2 to 2.2% over the next couple of years is probably in the cards.”

—  Dan Bastasic, MBA, CFA
Senior Vice-President, Investments iA Clarington Investments
 

Inflation risk: Greater consequences than in the past

Conservative income offerings, including investment-grade bonds, have long been a staple for investors to cover their income needs. But today’s income-seeking investors should be mindful of the inflation risk posed by relying too heavily on traditional “safer” income-generating options. Consider that a Government of Canada 10-year bond that is currently yielding 1.5% will actually provide a negative “real” return, with inflation running at 1.1%*

This recent heightened risk is in contrast to what many investors may have experienced over the previous few decades.

In the past, a “bond ladder” strategy of holding government bonds that mature and are replaced over a sequence of years offered a reasonably effective way for investors to generate income and offset inflation risk. As the general trend from 1985 onward saw rates and inflation gradually falling, and an overall decline in real yields on traditional bonds (Chart 1), investors were still able to benefit from a ladder that held positions in bonds issued in previous years which had higher yields. 

Chart 1: Senior Loan Prices

Chart

Source: Bank of Canada, August 31, 2016. Assumptions: Bought a new 5-year Government of Canada bond every December when one matured. Real yield is nominal yield minus year-over-year inflation.

 

A Government of Canada 10-year bond that is currently yielding 1.02% will actually provide a negative “real” return, with inflation running at 1.1%

 

 

Consider an investor (Investor A) who retired in 1985 with a $1 million laddered bond portfolio, relying on inflation-adjusted withdrawals starting at $50,000 annually (Chart 2).

The investor was able to generate cash flow at that level and still grow the value of the portfolio for close to twenty years. This in turn provided a healthy base for income generated in the future at lower rates. Contrast this with an investor (Investor B) retiring in 2000 with the same cash-flow requirements. With the onset of lower rates, modest inflation has been eating into this investor’s savings, resulting in a higher drawdown on capital and no portfolio growth. The outcome for an investor retiring today or in the near future looks even more concerning, given the general consensus for a sustained period of low rates for the foreseeable future

Chart 2: Bond ladder and withdrawal scenarios

chart

Source: Bank of Canada, iA Clarington Investments, August 31, 2016. Assumptions: Bought a new 5-year Government of Canada bond every December when one matured. Initial investment: $1M. Withdrawal: $50K, inflation adjuste 

 

Help reduce the risk

Chart 3: Income yields

Chart

Source: PC Bond, Credit Suisse, Bloomberg and Bank of Canada (August 31, 2016). Government represented by the FTSE TMX Canada All Government Bond Index, bond universe represented by the FTSE TMX Canada Universe Bond Index, IG corporates (investment-grade corporate bonds) represented by the FTSE TMX Canada All Corporate Bond Index, Canadian dividends represented by the S&P TSX Composite Dividend Index, senior loans represented by the Credit Suisse Leveraged Loan Index (USD), and HY bonds (high-yield bonds) represented by the BofA Merrill Lynch High Yield Master II Index (USD).

Investors seeking solutions to help offset the risk of inflation eroding their future purchasing power may wish to consider including alternative income investments as part of their overall portfolio. These alternatives might include senior loans, high-yield bonds and dividend-paying equities. In addition to their historical profile of producing inflation-beating returns, they all currently offer yields that readily outpace inflation (Chart 3).

Investors considering these alternatives should note that the added yield profile does come with an added level of risk – particularly credit and equity risk. For this reason, investors may want to consider a diversified, active approach that seeks to overcome these risks.

 

To help manage the risk of inflation, diversify your clients’ income portfolios with an active solution. Consider:

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Dealer use only . Statements by the portfolio manager or sub-advisor responsible for the management of the fund’s investment portfolio, as specified in the applicable fund’s prospectus (“portfolio manager”), represent their professional opinion, do not necessarily reflect the views of iA Clarington, and should not be relied upon for any other purpose. Statements that pertain to the future represent the portfolio manager’s current view regarding future events. Actual future events may differ. iA Clarington does not undertake any obligation to update the information provided herein.
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