Inflation: tick tock, tick tock…

old-clock

There is an old story about the head of the US Patent Office sending his resignation to U.S. President McKinley urging the closing of the patent office because “everything that could be invented has been invented”. The story’s legitimacy is debatable but when we hear modern pundits declare that it could forever be the end of inflation, we recall the lessons behind the infamous patent story.

So, what if this is not the end of inflation? That is a complex question, so to remain in context we’ll limit the discussion to what we can anticipate and how we can protect a portfolio against rising inflation/rates.

  • Government bonds will of course drop in value and with any hint of inflation they could move rather quickly. The longer-end (meaning longer dated bonds) will decrease faster than the shorter-end, as rates adjust to the new ‘inflation’ reality.
  • Investment grade corporate bonds will move in correlation to the government bond market.
  • The behavior of lower grade bonds won’t be as straightforward. There are some older lower grade corporate bonds with high coupons which have been priced only to the next call date. That is to say, the market has been assuming low rates and if these bonds can no longer be replaced with lower coupon debt at the call date, the market on these bonds will adjust favorably. This is because even though these bonds typically have much higher yields to maturity, they have been pricing off of their yield to call date, assuming it will be in the company’s interest to refinance at lower rates. It is important to have some of these bonds as portfolio protection. The Vertex Enhanced Income Fund has just over a 5.5% weight in these types of securities and the Vertex Fund has a 2.1% weight.

Below is an interesting chart provided by Morgan Stanley showing the outstanding leveraged debt maturity wall.

debt-wall

Leveraged debt will be some of the hardest debt to refinance since it is by its very nature at the risky end of the scale. Notice that there isn’t a lot to be refinanced over the next few years, as a result of the size of refinancing activity over the past nine months. This is positive for the market and gives room for refinancing as long as the US Federal Reserve makes good on its promise to keep rates low through 2015.

Hybrid bonds (we have talked about these previously), which are long-dated bonds with a fixed coupon that changes to a floating rate after 5-10 years, should also act in an interesting fashion. Because they have a large fixed coupon in their early years, they protect against deflation and with the conversion feature to floating rates, they protect in the long run against inflation. These bonds should not be correlated with the government bond market but will price off of future inflation expectations. If inflation is expected to go up considerably, the floating coupon will be expected to increase and thus the bond price should rise or at least not decrease. Most often these bonds are called at the first call date, so they too are priced off a yield to call date. If the market is not open for new issues in advance of the call date, the prices should rise as they are less likely to be called and worth more to the next call date or maturity. The Vertex Enhanced Income has approximately a 14.5% weight in hybrid securities and the Vertex Fund has approximately a 22.5% weight.

until next time. . .
@The Vertex Team

For information on this update or the funds we offer, please contact a regional VP of sales:

Noel Dattrino
(Western Canada)
604.408.5660

Michael Lindblad
(GTA & Eastern Ontario)
416.200.4457

James Wilson
(GTA & Western Ontario, Maritime Canada)
519.902.7780