Inflation shocks markets; FED on standby with rate hike

Inflation is becoming broad based

Inflation roared back in the month of August with both headline and core inflation numbers above economists’ forecasts. The significant decrease in energy prices did little to offset the increases in food, transportation, and rent costs, which came above projected numbers. Equity and bond indexes fell on the news, with a rate hike all but certain in September, and any hopes of a FED pivot all but erased. 

Not all Fixed Income is built the same

Fixed income investments are often touted as a lower volatility, and lower risk option to dividend paying equity investments. However, we have seen that in periods of high inflation and increasing interest rates this statement does not always hold true. Comparing the performance of Fixed income investments with that of the VYM, which tracks a basket of high dividend yield equities, we can clearly see a significant outperformance year to date in the latter. Therefore, investors must be careful with the type of fixed income they include in their portfolios, as not all fixed income is built the same. Let us examine the relative performance of various fixed income ETFs below.

A quick analysis of fixed income options

Starting on the low risk end of the spectrum we have the SHY, IEI, IEF and TLT Treasury Indexes. They all reacted negatively to the unexpectedly hot August inflation report; however, the magnitude of their reaction was quite different.  The SHY is made of low duration Treasuries with maturities between 1 and 3 years and was off by only 0.36%. The TLT on the other hand is made up of +20 year Treasuries and fell close to 1%, bringing the YTD losses to over 26% and dropping below its previous low level set in June. 

Moving higher up the risk spectrum, Investment Grade Bond ETF Indexes were also lower on the news, with ARCX:CORP and LQD down between -0.85% and 1% respectively for the day, closely matching the performance of longer duration treasuries. Year to date the 7-10 year Treasuries have outperformed Investment Grade bonds. So far, all is as expected with treasuries outperforming corporate bonds.

The pattern breaks down when looking at high yield debt, however. In comparison to their investment grade counterparts, high yield bonds have fared better over the last 9 months. ETFs such as HYG, which tracks an index of liquid high yield corporate bonds is down 15% YTD as of the writing of this article, compared to -18.3% YTD performance for the LQD, and closely matching the performance of 7-10 year Treasuries. Perhaps more surprising is the fact that the high yield bonds are outperforming 20-year treasuries by a large margin of more than 10%! 
Finally, we can observe the relative outperformance of inflation protected high yield bonds when looking at the interest rate hedged HYGH. This ETF is the best performing option among the previously mentioned names, save for the SHY. On a daily performance horizon, the HYGH seems nothing special (down 1.14% as of September 13), which represents almost a 2x drop compared to the LQD. However, on a YTD basis the HYGH strongly outperforms all other investment grade and high yield bonds, with a drop of only 6.7%. This far outranks most of the treasury ETFs listed above, and significantly outperforms the investment grade bonds contained in the interest rate hedged LQDI.

Please note this article is for information purposes only and does not constitute investment advice.