Impact of Inflation on Bond Funds
Inflation is of two types (a) demand-pull inflation (typically, when the economy is booming), and (b) supply-constraint inflation (typically, transitory). In order to curb demand-pull inflation, the central bank would try to reduce the velocity of money in the economy by increasing the interest rates.
The current spike in inflation is primarily due to supply constraint. However, in case of increase in inflation expectations, the long-end yields will be higher; while the central bank’s (Fed) actions impact the short-end of the yield curve.
The increase in bond yields implies drop in bond prices, that is, “mark-to-market losses”. However, a fall in bond prices means higher impact of “pull-to-par” (i.e., bond prices reaching the maturity par value) going forward.
From the bond investor point of view:
Higher interest rates mean higher bond yields, hence higher income for the bond investor from that point (see illustration 1). Further, “increase” in interest rates means the coupons and maturity proceeds of existing bonds can be redeployed at ‘prevailing’ high(er) interest rates (see illustration 2); which again is good news for the bond investors.
The key to enjoy increase in interest rates is the ability to hold the bonds through the “mark-to-market” loss period. Hence, short duration bonds make sense since they have much lower “mark-to-market” loss, while the proceeds can be redeployed at increasingly higher interest rates; thus, resulting in Higher Return.
In case of Silverdale Bond Fund:
Silverdale Bond Fund with its short duration (less than 2 years) and high-quality portfolio (78% IG) is uniquely positioned to benefit from the low cost of borrowing, higher yields and higher reinvestment rates. It should be noted that the cost of financing of the Fund is linked to actual Fed rates and not market expectations of rate hike. It is unlikely that the Fed would increase the interest rates before 2023. Hence, any market weakness, due to increase in inflation expectation, could provide a good investment opportunity.
In a nutshell, the increased inflation expectation and resulting uptick in short term interest rates provide a good investment opportunity to a medium -to- long term investor.
PS: In case of Silverdale Fixed Maturity Funds, typically, the spreads between bond yields and interest rates are largely locked-in using IRS (interest rate swap).
Illustration 1 – Impact of Leverage and Interest Rate Hike
Client Equity $100
Loan Taken by Fund $200
Total Investment by Fund $300
| Client Return on Investment (Ignoring frictions & costs) |
= 9/100 = 9% | Client Return on Investment (Ignoring frictions & costs) |
= 9.25/100 = 9.25% |
| Current Situation | On increase in Interest Rate by 0.25% | ||
| Interest earned (%) | : 5% | Interest earned (%) | : 5.25% |
| Interest earned by Fund | : 5% * 300 = $15 | Interest earned by Fund | : 5.25% * 300 = $15.75 |
| Interest expense (%) | : 3% | Interest expense (%) | : 3.25% |
| Interest expense by Fund | : 3% * 200 = ($6) | Interest expense by Fund | : 3.25% * 200 = ($6.50) |
| Net income of Investor | : $15 – $6 = $9 | Net income of Investor | : $15.75 – $6.50 = $9.25 |
Increase in interest rates result in bond coupons and bond maturity proceeds being invested at prevailing higher interest rates as well as increase in the spread between borrowing cost and bond yields resulting in higher spread income!
Illustration 2 – MTM “losses”
1 year bond carrying 6% coupon payable half-year
| Net Income to Investor | 6.09 | Net Income to Investor | 6.12 |
| No change in interest rates | Interest rate spikes by 2% immediately after purchase of the bond (i.e. mark-to-mark loss of 2%) |
||
| Cash-flows | Cash-flows | ||
| Initial Investment (Outflow) | -100 | Initial Investment (Outflow) | -100 |
| Fair value | 98 | Fair value | 98 |
| After 6 months: First Income Coupon |
+3 | After 6 months: First Income Coupon |
+3 |
| After 12 months: Second Income Coupon |
+3 | After 12 months: Second Income Coupon |
+3 |
| Interest on First Coupon (3 * 6% * 6/12) |
+0.09 | Interest on First Coupon (3 * 8% * 6/12) |
+0.12 |
| Maturity Amount (Inflow) | +100 | Maturity Amount (Inflow) | +100 |
Mark-To-Mark loss results in higher effective returns to investor
(*) The actual return will be different from indicative yield. The Fund may not be able to achieve its target returns. Past returns are not indicative of future returns.
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NOTICE
Many investors are concerned and curious as to the impact of higher inflation on bond funds. This article has been authored for the clients of Silverdale Capital Pte Ltd (“Silverdale”), for ease of understanding. It is neither exhaustive, nor an illustrative representation of the topic discussed.. Actual investment positions in the funds managed by Silverdale may, and often will, vary from its conclusions discussed herein based on any number of factors, such as investment restrictions, portfolio rebalancing and transactions costs, among others. Please refer to [Terms of Use] before relying or acting upon any information contained in this article.