After two decades of relative price stability, inflation has reasserted itself as a key risk for investors. On the institutional side, in addition to being exposed to wage inflation, Canada's defined benefit pension plans now have to spend more to offer their members post-retirement inflation protection. Rising prices are also boosting health benefit and claims costs for insurers, while foundations and endowments are struggling to maintain spending without eroding their capital.
Even Canadian Real Return Bonds (RRBs) – which are indexed to inflation and designed to hedge inflation risk – have drawn criticism from some corners. Certain commentators in the financial press recently noted that RRBs are not doing their job. So why are even inflation-indexed instruments such as RRBs falling short in the current inflationary environment? In fact, they aren't. But to see that requires a different analytical framework.
An asset-only perspective can lead investors to draw the wrong conclusions about the benefits of certain asset classes in mitigating inflation risk. According to a recent in-depth paper by TD Asset Management Inc. (TDAM), investors can make better decisions through an Asset Liability Management (ALM) framework, which incorporates analysis of liability-related risks in setting investment objectives.
Two perspectives for assessing inflation risk
The paper proposes two ALM-based perspectives for assessing the impact of inflation on portfolios: a long-term cash flow view (perspective 1) and a short-term market value view (perspective 2).
Within this framework, institutional investors should basically ask themselves two questions about the inflationary risk they face. Have my investments rewarded me with incremental inflation-adjusted cash flows (perspective 1)? On a year-over-year basis, how will the value of my assets fluctuate compared to the value of my liabilities (perspective 2)?
Under perspective 1, most asset classes offer investors some ability to hedge inflation-sensitive liabilities. Direct inflation-linked instruments, such as RRBs, have coupons and principal directly tied to the Consumer Price Index, providing an immediate and ongoing hedge for liability cash benefit payments. The inflation-hedging benefits of other asset classes are more evident over time, rewarding investors with higher cash flows and higher liquidation values, as economic growth and inflation boost asset prices.
Under perspective 2, the impact of inflation on asset and liability values will depend on the nature of the liabilities, how they are priced and discounted, and how financial markets value the securities backing them. Securities whose market values are affected by factors other than expected inflation will correlate imperfectly with inflation-linked liabilities.
For more details, read the full paper.
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