IVOL - IVOL: This Inflation Hedge Is About To Break Out

2024-01-16 23:57:12 ET

Summary

• The Quadratic Interest Rate Volatility and Inflation Hedge ETF is breaking out to the upside amid falling real yields and a steepening yield curve.
• IVOL should benefit from the ongoing deterioration in government finances, which should drive real yields lower across the board and a normalisation of the yield curve.
• The main risk comes from the ETF underperforming its stated objectives.

While most markets seem to have declared victory over inflation, the Quadratic Interest Rate Volatility and Inflation Hedge ETF ( IVOL ) looks to be breaking out to the upside. IVOL acts as an inflation hedge, due to its holdings of inflation-linked bonds, as well as a hedge against yield curve steepening. Both of these forces are likely to join together as fiscal risks worsen, and I expect them to launch the IVOL higher. The risk, however, is that the ETF continues to decouple from its underlying drivers as we have seen over recent months.

The IVOL ETF

IVOL is a fixed-income ETF that holds a portfolio of inflation-linked bonds and options that seeks to hedge against a steepening yield curve, whether from falling short-term interest rates or rising long-term interest rates. The bulk of the IVOL's assets are held in the Schwab U.S. TIPS ETF ( SCHP ) which holds inflation-linked bonds with an average maturity of 7.1 years, which benefit from rising inflation expectations. The remainder is held in OTC options which seek to benefit from yield curve steepening, specifically the spread between 2-year and 10-year interest rate swaps. As a result, the fund is intended to benefit during periods of rising breakeven inflation expectations relative to interest rate expectations, which drive up the SCHP, and also when the 2s-10s yield curve steepens. The ETF also pays an impressive 3.7% dividend yield, which reflects CPI-linked payments.

Well Positioned To Benefit From Fiscal Deterioration

Both the SCHP and the 2-10 yield spread have moved sharply higher over recent months, and I expect further increases in both as inflation expectations recover following an overshoot to the downside and the yield curve continues to normalise. The 1.8% yield on the SCHP remains highly attractive in the context of the government's dire fiscal position. The budget deficit is currently at 6.5% of GDP despite the economy being at full employment, and total debt is pushing up towards 130% of GDP, creating a clearly unsustainable situation.

With little hope of any return towards a balanced budget any time soon, the Fed will be forced to help fund the Treasury by steering real interest rates lower. In doing so, inflation expectations are likely to rise, causing investors to reduce bond duration due to the risk of rising long-term yields. Both these factors should benefit the IVOL.

Tracking Error Is A Risk

As I noted in my previous article in August the ETF's strategy essentially boils down to a long position on 2-year bonds and a short position on long-term inflation expectations. The reason being that the fund has long exposure to bonds through its SCHP holdings and short exposure via swaps, which broadly net out. This can be seen in the chart below, which shows the IVOL versus the spread of 10-year breakeven inflation expectations over 2-year bond yields.

The problem is that over the past few months, the IVOL has not followed the spread higher as one would expect. From its lows in September, the IVOL is up around 5% in total return terms but based on the 12-month correlation returns should have been above 10%. While such discrepancies have occurred in the past for short periods, the recent underperformance is a concern to watch.

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