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Weekly Credit Insight

Chart of the week: the withering cushion

Risks in the current environment are plentiful: in previous weeks we’ve discussed the probability of a rise in unfavourable corporate behaviour, as well as the chance a taper tantrum might emerge. This week, we focus on inflation.

The reach-for-yield environment means that the cushion offered by the coupons is dwindling. A significant part of long-term returns within fixed income comes from the coupon, or the so-called carry component.

By dividing yield by duration – this is a measure of the sensitivity of a debt instrument to a change in interest rates – we can calculate the ‘cushion’ that the yield currently offers against a market widening. Figure 1 plots that relationship for the Barclays Global Aggregate index over the last 20 years.

Figure 1. The yield cushion

Source: Federated Hermes, Bloomberg LP, as at December 2020.

Given that duration is at record highs and yield is near all-time lows, the breakeven is also at an all-time low of just 12bps. This high sensitivity to rates will be dangerous if inflation expectations increase and government bonds consequently move higher.

In the end, inflation could help us manage the debt pile the world has accumulated. How should we navigate this market characterised by higher volatility and a withering cushion from carry? Find out in our recent Delta podcast.


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