Inflation and structured products

Inflationary pressures dominated the world economy in the 1970s. This was caused primarily by the sudden rise in oil prices and global shifts in currencies, trade and wealth. This eased in the 1980s as freer markets and stock market growth took over. Inflation has not really featured since and was declared dead by many commentators after the global financial crisis of 2008 when attention turned to resurrecting economies burdened by debt and showing no signs of growth. However, Inflation has started to creep back into the narrative in the last few years as the effects of the global financial crisis were finally shaken off and economies started to expand.

Inflation in today’s markets

It took the extreme events of 2020 to bring another flavour of inflation into the picture with the consequences of the Covid 19 pandemic. We can add the concept of “supply shortages” to the more common economic labels of “demand pull” and “cost push” inflation. Supply shortages affected trade, shipping and labour and caused widespread social and economic disruption. This had a knock-on effect of prices: US inflation (CPI) now stands at 7%, the highest level since December 1981 and UK RPI is at 4.8%, the highest seen since 1992. Meanwhile, Eurozone inflation is at a record 5% in the twenty years it has been calculated (Sources: BIS, ONS, ECB). A similar picture is true in many other economies indicating that inflation has now fully cast its shadow on world economies and markets.

The rising inflation picture has seen a corresponding rise in interest rates, with all three currencies below showing an increase in rates as measured by the 5 year zero coupon rate over a 12 month period.

Generally what is called the “real rate of return” (the difference between interest rates and inflation) is relatively stable over the medium term which has occurred here with both inflation and rates rising. Historically the real rate of return is expected to be positive so that those investing in cash would receive a return over inflation (a “real return”). Given that rates have been near zero since 2008 it has been many years since most economies have experienced a positive real return. Negative real returns mean that it is impossible for an investor to match inflation without taking risks.

Mitigating inflation risk

There are many ways to try to hedge or mitigate inflation risk. Equity investments can be a natural choice since companies’ earnings are themselves often linked to inflation. The best equities to protect against inflation are usually low volatility high yielding cash rich businesses such as utilities and food and staples groups.

In several important markets inflation linked government bonds have been issued for many years. These include the US, UK, Eurozone and Japan. Governments like to issue these types of bonds since their taxation take tends to be strongly inflation linked. This applies to both sales and income tax revenues which are exposed to prices and wages respectively. Therefore, governments issue such bonds knowing their income and liabilities are closely matched.

Impact on structured products

In the past, structured products have been issued directly linked to inflation, these were particularly popular in the UK ten to fifteen years ago, however they have now virtually disappeared. This is due to low interest rates and the fact that inflation linked bonds tend to be heavily bought by insurance and pension funds seeking to hedge long term liabilities. Because the actuarial and risk averse approach that such funds take favours risk reduction rather than maximising return the price of the inflation bonds gets driven up to the point that the break-even inflation rate that can be implied relative to conventional fixed rate bonds becomes much lower than current inflation expectations. Because of this, the returns of such structured products would become unattractive for anyone except those convinced that inflation was set to increase strongly.

Given that inflation linked products are now very hard to put together, structured product distributors wishing to maintain product issuance when investors are worried about rising inflation or interest rates must adopt other approaches. Such alternatives ideas take advantage of the flexibility and range of the structured products market.

Alternative solutions

The first solution is to issue products of a shorter maturity than might normally be the case. This will avoid being locked into rates in a rising environment or have returns eroded by inflation. Issuing a five year product instead of an eight year one for example will tie investors’ money up for a shorter period allowing re-investment at higher rates if inflation continues to rise.

Other simple strategies include keeping products closer to delta 1 than might otherwise be employed because this gives such investments less interest rate exposure although this has the effect of potentially increasing the risk level. For those investors that do need income it might be more logical to offer floating rate rather than fixed rate interest. Sadly, this is a solution that is rarely adopted in most markets despite its benefits principally because of the extra complexity that has to be explained to a retail investor base.

The final alternative that could be considered is that of commodities which should perform well in a world of increasing inflation. Energy is the most obvious sector to tap into but structuring products can be difficult given volatility, forward curves and the cost of hedging. Decades ago, gold used to be thought of as the perfect inflation hedge and its price has shown decent growth in the last few years which may lead to an uptick in its popularity.

In conclusion we see that inflation is once again a material concern with supply issues causing an unfamiliar market environment. Structured products distributors and advisers should be aware of their investors needs and maintain a flexible and prudent approach in the next year or two as this plays out.