What it means
Inflation reduces the buying power of money. Bonds that pay a fixed amount lose value in real terms when prices rise, while some other assets tend to hold their value better.
An inflation trade is a deliberate shift of an investment portfolio towards the second group. Common instruments include inflation-linked bonds, commodities such as oil, gold or industrial metals, real assets such as property and infrastructure, and shares in companies with strong pricing power.
Investors may also use inflation swaps or shorten the average life of their bond holdings, because shorter bonds are less sensitive to rises in interest rates. A classic version is the breakeven trade.
The breakeven inflation rate is the gap between the yield on an ordinary government bond and the yield on an inflation-linked bond of the same maturity. An investor who thinks actual inflation will exceed that gap buys the inflation-linked bond and sells the ordinary one.
The trade is not risk free. Inflation might fall, rates may rise and push down the prices of bonds, or an asset such as gold may behave differently from expectations.
Because many investors rush into the same trades when inflation fears grow, protection can become expensive just when people want it most. For a business, the lesson is to look at its own exposure.
A company with costs that rise with inflation and fixed-price contracts is hurt by higher prices, while one that can pass costs on is less affected. Treasury teams may use inflation trades to offset these exposures, and personal investors may hold a modest amount of inflation protection in their portfolios.
Timing is the hardest part. Inflation expectations are already reflected in market prices, so the trade only pays if inflation turns out different from what the market expects.
In practice
Real-world examples.
Example
An investor worries that prices are rising faster than official forecasts. She moves $50,000 from long-term fixed-rate bonds into inflation-linked bonds. If inflation stays high, her bond income and principal will rise with it. She keeps the rest of her savings in cash and shares.
Example
A hedge fund believes that markets are underpricing future inflation. It buys inflation swaps and sells a similar amount of ordinary government bonds. The trade gains if inflation surprises on the upside and loses if it falls. The fund limits the size of the position to a small share of its capital.
Example
A family-owned manufacturer with large energy bills buys oil futures to offset a rise in fuel prices. Its finance director sees this as an inflation trade that protects the budget. Profit is steadier even when costs spike. The director records the hedge in the budget notes so that results can be explained.
Formula
Calculation
Breakeven inflation rate = Nominal bond yield - Real bond yield
Suppose a 10-year government bond yields 4.5% and a 10-year inflation-linked bond yields a real return of 2.0%. The breakeven rate is 4.5% - 2.0% = 2.5% a year.
An investor who expects average inflation of 3.5% over the next ten years would buy the inflation-linked bond. If she is right, the inflation-linked bond earns 2.0% plus 3.5% = 5.5% a year, compared with the 4.5% from the ordinary bond. On $100,000 invested, that is an extra 1.0% or about $1,000 per year in the first year.Case study
Seen in the real world.
Ashcroft Capital is a fictional investment firm managing $80,000,000 for a charitable foundation. The foundation must pay out a fixed share of its assets each year, and its board worried about the effect of inflation on the real value of its grants.
The portfolio managers moved 20% of the fund, or $16,000,000, into inflation-linked bonds, real estate and commodity funds, and reduced the holdings of long fixed-rate bonds. They set a rule to review the allocation each quarter. They also agreed a limit on how much any single asset could represent.
In this illustrative case, inflation rose more than expected over the next two years, and the new holdings helped to preserve the real value of the fund. The board noted, however, that the commodity funds had been volatile and that the benefits of the strategy depended on how events unfolded.
Watch out
Common mistakes.
- Assuming inflation protection is free, when the price of protection often rises as inflation fears grow.
- Treating all real assets as the same, when property, gold and commodities respond differently.
- Forgetting that rising inflation often leads to higher interest rates, which can hurt bond prices even when they carry some inflation protection.
Questions
People also ask.
What is an inflation trade in simple terms?
It is a way of positioning investments so they gain, or lose less, when prices rise.
What is the breakeven inflation rate?
It is the nominal bond yield minus the real bond yield, showing the inflation rate the market is pricing in.
Can individuals make inflation trades?
Yes, through inflation-linked bonds, commodity funds or property, though they should understand the risks and costs, including fund fees and the chance of losses if inflation falls.
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