Which Fixed-income Sectors Are Good Inflation Hedges?

Expectations that measures of inflation will show increase in the near to medium term have driven up yields at the long end of the yield curve, with long term treasury ETFs dropping to the bottom of our trend table.  In contrast, SPDR DB International Inflation Protected Bond ETF (WIP) and SPDR Barclays High Yield Bond ETF (JNK) have delivered solid gains in the past three months. We believe two bond sectors—non-dollar denominated inflation-hedging credit and high yield bonds—will continue to perform well in a rising interest rates environment.

What are the forces driving inflation globally?
1. Inflationary pressure triggered by rising commodity prices and capital inflow to stay in emerging markets in the foreseeable future 
Inflation will likely stay high in the emerging countries due to rising commodity and food prices and wage pressure, while capital inflow from developed markets seeking for higher yields continue to drive up asset prices. As many emerging economies focus on developing and expanding their middle class, consumers in these countries continue to improve their standards of living. These secular forces are driving a shift of consumption patterns in emerging markets leading to higher food and energy prices. Although not immune to short-term downside surprises, in the long term the upward-moving direction of commodity prices seems clear and will likely stay in course due to the commodity intensive nature of developments in emerging countries. At the same time, many EM currencies are pegged to the U.S. dollars, and easy monetary policy in the U.S. will continue to drive inflow of capitals into the emerging markets, pushing price levels even higher.

2. Emerging markets can no longer serve as a source of disinflation for the developed world
High price levels in the emerging markets mean developed economies can no longer rely on the emerging markets as a source of disinflation like in the past two decades. Consumers in the developed world will face higher import prices as a result of the higher input and wage costs of the imports.

What fixed-income sectors will perform well against rising rates?
In addition to the embedded hedge against weakening dollar, SPDR DB International Inflation Protected Bond ETF (WIP)  will likely fare well in an inflationary environment given the inflation-hedging nature of the underlying credit. We believe this ETF has a healthy yield (2.84%) and duration (9.43 years).

SPDR Barclays High Yield Bond ETF (JNK) offers attractive credit spread in the medium-term duration space and provide a good balance of high coupon (8.30%) and ideal duration (4.53 years). This ETF has a convexity of -0.02%, offering solid yield cushion in rising rate environments. The fund's credit quality is backed by the healthy growth prospect of the underlying holdings. The fund is heavily tilted towards two sectors, with about 80% of its underlying holdings issued by industrial companies and about 10% by financial institutions.

We developed a fixed income model portfolio and the current holding of the strategy is 50% in high yield (JNK) and 50% in international inflation protected (WIP). This model portfolio has delivered a 9.4% return in the past one year, outperforming benchmark iShares Aggregate bond (AGG) by 122%, which gained about 4.2% in the same period. For a list of historical transactions this strategy has made, please refer here.

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