To conclude our three part series on inflation, we cover the current inflation environment and provide a practical example of how Venn can be used to manage inflation risk in a portfolio. Please refer to the first post for a foundational understanding of Venn’s Local Inflation factor and the second post for an analysis of three assets that are commonly viewed as inflation hedges.

Inflation Breakevens and the Current Environment

The inflation breakeven rate can be a way for investors to gauge the market’s inflation expectations. It is calculated as the difference between the yield of a nominal bond and an inflation-linked bond with the same maturity. To a first approximation, the 10-year breakeven inflation rate implies what market participants expect inflation1 will be over the next 10 years2

A time series plot of the 10-year breakeven inflation rate is provided below. We see that during the COVID-induced market crash in February and March 2020 inflation breakevens fell dramatically. This is likely due to falling inflation expectations, but could also be due to other factors, including relative liquidity differences between nominal and inflation-linked bonds.3 However, if we view breakevens as a proxy for expected inflation, we see it has been rising since mid-April on the back of massive fiscal stimulus from governments around the world to mitigate the economic effects of the pandemic. 


Exhibit 1: 10-Year Breakeven Inflation Rate

Source: Federal Reserve Bank of St. Louis as of February 22, 2021.



Given this apparent concern of rising inflation, how can Venn help investors manage their inflation risk in practical terms? Before we jump into an example in the next section, we should first make the connection between inflation breakevens and Venn’s Local Inflation factor. 

Venn’s Local Inflation factor, in its raw implementation (i.e., no residualization to other factors), attempts to capture the market’s expectations for inflation, thereby providing a hedge to inflationary risk. Recall from the first post in this series that the raw Local Inflation factor input is the total return difference between an inflation-linked bond index and a Treasury index. By construction, it gains when realized inflation is high vs. expectations, and expectations are captured by breakeven inflation. Hence, unsurprisingly as shown below, over the last five years, our raw Local Inflation factor has exhibited a 97% correlation with breakeven inflation changes. 


Exhibit 2: Correlations Between Local Inflation Factor Inputs and Breakeven Inflation

Source: Venn as of January 15, 2021. Time period: January 13, 2016 - January 12, 2021, using rolling five-day returns.


However, in practice Venn residualizes the less liquid Local Inflation factor to the more liquid core macro factors, three of which (Equity, Credit, and Commodities) also have positive correlations with breakeven inflation changes over this period, reflecting some inflation hedging capability embedded in those risk factors. Therefore, when using Venn’s Factor Analysis results for a portfolio or investment, it’s important to consider not only your Local Inflation exposure, but also your exposure to the core macro factors, and how they play into your inflation exposure.


Managing Fixed Income Portfolio Inflation Risk in Venn: Example

We’ll now provide an example of how you can manage your inflation risk in Venn. For example, let’s play the role of a fixed income portfolio manager for an allocator who wants to understand the extent to which her portfolio is hedged against inflation. Here is the current portfolio allocation across various fixed income sectors and managers:


Exhibit 3: Starting Allocation of the Fixed Income Portfolio

Source: Venn as of February 24, 2021. Allocations are in USD millions.




The portfolio is allocated 42% to a core fixed income fund, 32% to a corporate bond fund, and 26% split equally between two high-yield bond funds. 

To gauge the extent to which the portfolio is hedged to inflation, we can use Venn’s Factor Analysis to understand its exposures to Local Inflation as well as the core macro factors it’s residualized against (similar to our analysis in the second blog post in this series). A simpler analysis would be to look at the portfolio’s univariate beta to the Bloomberg Barclays US 10 Year Breakeven Inflation Index, available in Venn here, which has a 97% correlation since May 2006 with Venn’s raw, unresidualized Local Inflation factor.


Exhibit 4: Historical Risk Statistics of the Fixed Income Portfolio

Source: Venn as of February 24, 2021. Time period: February 20, 2016 - February 19, 2021, using rolling five-day returns.


The beta shown here is one way to measure your portfolio’s sensitivity to changes in inflation expectations. So what does this beta actually mean? In short, you can interpret the portfolio’s 0.05 beta as follows: if breakeven inflation goes up by 10 bps, the portfolio is expected to return 2.4 bps.4 This result suggests that the portfolio is positively correlated with changing inflation expectations.

Now say this portfolio manager was concerned about potential rising inflation and wanted to further hedge the portfolio against that risk. She is considering a TIPS (i.e., Treasury Inflation-Protected Securities) fund and wants to see how that might shift her factor exposures and inflation sensitivity. She wants to test allocating to the TIPS fund by reducing the exposure to core fixed income. 


Exhibit 5: Updated Allocation of the Fixed Income Portfolio

Source: Venn as of February 24, 2021. Allocations are in USD millions.


Let’s see the effect this had on the portfolio’s sensitivity to changes in inflation expectations.


Exhibit 6: Historical Risk Statistics of the Updated Fixed Income Portfolio 

Source: Venn as of February 24, 2021. Time period: February 20, 2016 - February 19, 2021, using rolling five-day returns. The Bloomberg Barclays US 10 Year Breakeven Inflation Index is the benchmark.


Indeed, the updated portfolio has a higher sensitivity to inflation expectations, suggesting the portfolio is better hedged than the original portfolio to rising inflation. From here she can test out other potential portfolio allocations that include inflation hedges, such as gold and natural resource equities (using the same process outlined above), to see how she can further increase her portfolio’s sensitivity. 

We may not know where the path of future inflation may go, but at the very least we have shared some steps that investors might want to consider to understand the extent to which their portfolios are hedged to inflation risk and possibly take action to guard against it. Click here to use Venn to manage your organization’s inflation risk.



1 As measured by the Consumer Price Index. 

2 Though in theory, yield difference between nominal bonds and inflation-linked bonds with the same maturity include more than just expected inflation. For example, it also may include an inflation risk premium, as we mentioned in our first post. Relative liquidity differences and short term investor demand can also affect pricing. 

3 Source: Markets in the Rear-View Mirror: COVID-19 Collision.

4 To convert from return space to yield change space, we need to multiply the beta by the duration. If we approximate the duration of the bonds in the TIPS and Treasurys indices as 8, then we can say that if inflation expectations go up by 10 bps, real yields will go down by 10 bps (assuming this move does not affect nominal yields) and TIPS’ return will be +80 bps. After multiplying by a beta of 0.03, the portfolio will go up by 2.4 bps.


This article is not an endorsement by Two Sigma Investor Solutions, LP or any of its affiliates (collectively, “Two Sigma”) of the topics discussed. The views expressed above reflect those of the authors and are not necessarily the views of Two Sigma. This article (i) is only for informational and educational purposes, (ii) is not intended to provide, and should not be relied upon, for investment, accounting, legal or tax advice, and (iii) is not a recommendation as to any portfolio, allocation, strategy or investment. This article is not an offer to sell or the solicitation of an offer to buy any securities or other instruments. This article is current as of the date of issuance (or any earlier date as referenced herein) and is subject to change without notice. The analytics or other services available on Venn change frequently and the content of this article should be expected to become outdated and less accurate over time. Any statements regarding planned or future development efforts for our existing or new products or services are not intended to be a promise or guarantee of future availability of products, services, or features.  Such statements merely reflect our current plans.  They are not intended to indicate when or how particular features will be offered or at what price.  These planned or future development efforts may change without notice. Two Sigma has no obligation to update the article nor does Two Sigma make any express or implied warranties or representations as to its completeness or accuracy. This material uses some trademarks owned by entities other than Two Sigma purely for identification and comment as fair nominative use. That use does not imply any association with or endorsement of the other company by Two Sigma, or vice versa. See the end of the document for other important disclaimers and disclosures. Click here for other important disclaimers and disclosures.

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