Investment Insight | Responding to inflation
The Inflation Category fulfills an important role in the investment solutions that NZ Funds offers to clients. At their heart, Inflation Category portfolios are, as the name suggests, looking to achieve a return that grows clients’ capital at the rate of inflation or better.
Given this goal, a mix of asset classes are required. An allocation to growth assets such as shares is needed to generate returns that can be expected to be consistently ahead of inflation. However, these portfolios are not intended to experience the ups and downs that pure growth portfolios, such as those which invest fully in shares, do.
As a result, a percentage of Inflation Category portfolios have been invested in less volatile income assets such as bonds. Bonds are more stable investments, but the trade-off is that they offer a lower rate of return than shares.
Given the goal of beating inflation, income assets utilised in Inflation Category portfolios have targeted bonds that generate a higher return than plain vanilla bonds (or using market jargon, 'investment grade bonds'). This has included high-yield bonds and more specialised parts of the bond market such as hybrid bonds and convertible preference shares.
All of these securities, as the preference share name suggests, incorporate features that mean they sit somewhere between lower-risk investment-grade bonds and more volatile shares. These types of securities have helped the Inflation Category achieve target returns since the first Portfolios were established more than 10 years ago.
Over time the inflation goal for the Inflation Category has not changed – clients need to know what the Portfolios are aiming to achieve. However, a key part of NZ Funds' active management philosophy is a willingness to recognise that the asset types which we invest in to meet these goals will need to change over time – asset allocation is not set and forget. This is especially true now in this world of ultra-low interest rates.
The combination of low interest rates for riskless government securities and plentiful liquidity have resulted in super-low yields for even the 'riskier' income assets such as high-yield and hybrid bonds. Instead of a yield of 6%, 7% or even 8%, these securities are yielding 3% or 4%. Pair this with a general pick-up in inflation and we are now faced with the very strange situation that the returns available from high-yield bonds are, in most cases, below the rate of inflation.
The graph shows this very vividly as the U.S. High Yield Bond Index is now below the rate of inflation. If clients are invested into these securities, they would effectively be losing money after the impact of inflation.
The clear message that this graph tells us is that it will be difficult for income assets to achieve the return necessary to meet the intended goals of Inflation Category portfolios. In response, the allocations within these Portfolios have changed over the last year in the following ways.
An increased share allocation in the Portfolios.
Adding more shares adds more risk to the Inflation Portfolios; however, we believe that – as the economy recovers from the disruption caused by COVID-19 – the potential earnings growth generated by companies and the returns available from shares outweigh the additional risk.
Adding an allocation to inflation sensitive assets such as commodities
In general, the last twenty years of low inflation have been a difficult period for commodities. This reflects that commodities are sensitive to inflation – when inflation increases the cost of building new mines (creating new supply) also increases, so any commodities currently produced are worth more. In an environment where inflation is generally running at a higher level, commodities are expected to perform well.
Alternative yield strategies such as merger arbitrage.
Low interest rates and readily available funding has led to an increase in companies buying other businesses (in market jargon, this is known as 'mergers and acquisition' or M&A). The investment technique of merger arbitrage is a way for Inflation Category portfolios to earn an attractive yield by investing in these companies.
Typically, a company which is being taken over will trade in the market at a small discount to the announced purchase price. This discount will reflect both uncertainty around the potential for the acquisition being completed (for example the deal may need regulatory permission) and the fact that most investors will be happy to bank the bulk of their return and then move on to the next investment, rather than wait for the deal to complete.
This small discount can be an attractive lower risk investment opportunity given the short time frame. For example, a company may be trading at a 3% discount to its eventual takeover price. This is a small return but if it can be achieved in a short space of time – say three months – then this is an effective return of 12% per annum. By investing repeatedly in these short-term opportunities, Inflation Category portfolios generate an attractive above inflation return over the full year.
NZ Funds' active management involves much more than deciding which individual shares or bonds to buy and sell. It is also about stepping back and giving consideration to the economic environment to identify which asset classes have the best ability to build clients' long-term wealth.
Given this goal, a mix of asset classes are required. An allocation to growth assets such as shares is needed to generate returns that can be expected to be consistently ahead of inflation. However, these portfolios are not intended to experience the ups and downs that pure growth portfolios, such as those which invest fully in shares, do.
As a result, a percentage of Inflation Category portfolios have been invested in less volatile income assets such as bonds. Bonds are more stable investments, but the trade-off is that they offer a lower rate of return than shares.
Given the goal of beating inflation, income assets utilised in Inflation Category portfolios have targeted bonds that generate a higher return than plain vanilla bonds (or using market jargon, 'investment grade bonds'). This has included high-yield bonds and more specialised parts of the bond market such as hybrid bonds and convertible preference shares.
All of these securities, as the preference share name suggests, incorporate features that mean they sit somewhere between lower-risk investment-grade bonds and more volatile shares. These types of securities have helped the Inflation Category achieve target returns since the first Portfolios were established more than 10 years ago.
Over time the inflation goal for the Inflation Category has not changed – clients need to know what the Portfolios are aiming to achieve. However, a key part of NZ Funds' active management philosophy is a willingness to recognise that the asset types which we invest in to meet these goals will need to change over time – asset allocation is not set and forget. This is especially true now in this world of ultra-low interest rates.
The combination of low interest rates for riskless government securities and plentiful liquidity have resulted in super-low yields for even the 'riskier' income assets such as high-yield and hybrid bonds. Instead of a yield of 6%, 7% or even 8%, these securities are yielding 3% or 4%. Pair this with a general pick-up in inflation and we are now faced with the very strange situation that the returns available from high-yield bonds are, in most cases, below the rate of inflation.
The graph shows this very vividly as the U.S. High Yield Bond Index is now below the rate of inflation. If clients are invested into these securities, they would effectively be losing money after the impact of inflation.
The clear message that this graph tells us is that it will be difficult for income assets to achieve the return necessary to meet the intended goals of Inflation Category portfolios. In response, the allocations within these Portfolios have changed over the last year in the following ways.
An increased share allocation in the Portfolios.
Adding more shares adds more risk to the Inflation Portfolios; however, we believe that – as the economy recovers from the disruption caused by COVID-19 – the potential earnings growth generated by companies and the returns available from shares outweigh the additional risk.
Adding an allocation to inflation sensitive assets such as commodities
In general, the last twenty years of low inflation have been a difficult period for commodities. This reflects that commodities are sensitive to inflation – when inflation increases the cost of building new mines (creating new supply) also increases, so any commodities currently produced are worth more. In an environment where inflation is generally running at a higher level, commodities are expected to perform well.
Alternative yield strategies such as merger arbitrage.
Low interest rates and readily available funding has led to an increase in companies buying other businesses (in market jargon, this is known as 'mergers and acquisition' or M&A). The investment technique of merger arbitrage is a way for Inflation Category portfolios to earn an attractive yield by investing in these companies.
Typically, a company which is being taken over will trade in the market at a small discount to the announced purchase price. This discount will reflect both uncertainty around the potential for the acquisition being completed (for example the deal may need regulatory permission) and the fact that most investors will be happy to bank the bulk of their return and then move on to the next investment, rather than wait for the deal to complete.
This small discount can be an attractive lower risk investment opportunity given the short time frame. For example, a company may be trading at a 3% discount to its eventual takeover price. This is a small return but if it can be achieved in a short space of time – say three months – then this is an effective return of 12% per annum. By investing repeatedly in these short-term opportunities, Inflation Category portfolios generate an attractive above inflation return over the full year.
NZ Funds' active management involves much more than deciding which individual shares or bonds to buy and sell. It is also about stepping back and giving consideration to the economic environment to identify which asset classes have the best ability to build clients' long-term wealth.
Source: Bank of America Merrill Lynch, Bloomberg.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
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Mark Brooks is Portfolio Manager for New Zealand Funds Management Limited (NZ Funds) and a member of the NZ Funds KiwiSaver Scheme. Mark's comments are of a general nature, and he is not responsible for any loss that any reader may suffer from following it.
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