Investors forced to look at new types of inflation-linked assets

According to the UK Treasury, the UK public sector has long-term pension liabilities of about £1000bn ($1576bn). Add in the private sector and the bill rises to between £2000bn and £3000bn. Most of those liabilities are index-linked, so they should ideally be funded by inflation-linked assets.

The UK pension industry is particularly sensitive to inflation but in many other parts of the world there are increasing worries about the impact of inflation on pension liabilities. Governments are battling with ageing demographics, accounting regulations are becoming harsher and a number of countries in mainland Europe are trying hard to shift the funding of pensions from the public to the private sector.

Traditionally, pension funds have aimed at protecting themselves against inflation in two ways: through equities and index-linked government bonds (known as sovereign linkers). But changing legislation, obliging funds to match their assets and liabilities more closely, has made trustees question the dominance of stocks and shares in their funds’ portfolios. Market behaviour since the financial crisis, moreover, has highlighted weaknesses in both equities and sovereign linkers.

Risky assets?

Successive downgrades by Standard & Poor’s and Moody’s, for example, sent Greek bonds below investment grade last year. Greece subsequently dropped out of key inflation-linked bond indices so investors tracking those benchmarks had to sell their Greek linkers, invariably taking a heavy hit in the process. The pattern is less extreme elsewhere in the eurozone, as countries such as Spain and Portugal have barely featured in the sovereign linker market. Nonetheless, the Greek experience serves as an uncomfortable reminder that index-linked debt is not always a low-risk investment.

This is particularly apposite as investors cast around for alternative inflation-linked assets. 

“There is a massive demand for inflation from pension funds,” says Adrian Bell, head of debt advice and origination at boutique house Evolution Securities.

In the UK, some of this demand can be satisfied by index-linked gilts, a market cultivated over many years by the UK government. But there are about £300bn of index linked gilts outstanding, a tiny fraction of UK pension funds’ requirement for inflation-protected assets.

The extent of demand can be seen by the price at which UK index-linked gilts are trading. Sovereign linkers from countries such as Greece may have been shunned by investors but the UK still retains its AAA rating and the appetite for its government debt is extraordinary.

“Real yields on inflation-linked government bonds have fallen dramatically, reflecting huge demand for these assets. They are actually offering a negative real yield,” says William Nicoll, a director of fixed-income at fund management firm M&G. “The real problem for pension funds and other investors looking for inflation protection is that there is a limited source of supply,” he adds.

Examining the corporate market

The corporate market seems, at first glance, an obvious place to look. UK utility National Grid, for example, recently took advantage of retail demand for inflation protection, issuing a £260m index-linked bond, specifically targeted at the UK retail investor. The largest retail bond issue on the London Stock Exchange’s retail order book to date, the deal highlighted individual investors’ appetite for linkers. National Grid has tapped the institutional market on several occasions too but it is one of the relatively few companies suited to this sector.

“If corporates do not have long-term revenues linked to inflation, they have a limited interest in issuing inflation-linked bonds,” says Sebastien Goldenberg, global head of inflation-linked solutions at Citi.

“It is quite a stubborn market. Only a small number of companies want to do linkers and investors tend to buy and hold so it is relatively illiquid,” says Mr Nicoll.

Utilities short in supply

Utilities are the most obvious corporate issuers, as their revenues are directly tied in to inflation but, according to Marco Baldini, head of European corporate syndicate at Barclays Capital: "A lot of utilities have already accessed the inflation-linked market so supply is not particularly strong. The supply imbalance is more extreme than it used to be."

Companies such as BAA, a quasi-utility, and supermarket chain Tesco, which has its income notionally tied to inflation, have also issued index-linked bonds in recent months, each time to rapturous response, but this does not mean investors will accept any issuer that cares to tap the market.

“Just as there is a defined range of issuers that are comfortable taking on inflation risk, so there are also comparatively few issuers that investors feel comfortable with. They are extremely wary of low-quality credit,” says Francois Bleines, head of corporate syndicate at Deutsche Bank.

Creditworthiness is even more of an issue in the linker market than in the plain vanilla sector because even though coupons are relatively low, the principal that borrowers have to repay is invariably above par, reflecting inflation through the life of the bond.

“Certain linkers carry a greater credit risk than conventional bonds for a given maturity, due to a greater capital loss in case of default,” says Mr Goldenberg.

“There is precious little appetite for risk at present,” adds Franck Triolaire, global head of inflation trading at BNP Paribas.

Changing landscape

Before the financial crisis, the situation was rather different. Issuance was wide and varied and the index-linked market thrived.

“Between 1990 and 2005, we saw £12bn in index-linked non-sovereign issuance. Between 2005 and 2007, that surged to £27bn. The industry was relying on monoline insurers to help borrowers below investment grade issuing long-dated linkers,” says Mr Goldenberg.

The death of the monoline insurer put paid to that particular sector of the market but activity before the crisis was also bolstered by a wealth of issuance from public-private partnerships or PPP infrastructure deals.

“If index-linked government bonds are the largest source of inflation-linked assets, then infrastructure was always the second largest. Most of the debt was held by banks but they would use the inflation element of these deals to create and sell swaps. Pension funds were natural buyers,” says Mr Nicoll.

Many other deals were structured in this way too, including linkers issued by utilities and some property companies. Indeed, many investment banks believe inflation-linked swaps are the most suitable way for pension funds to buy inflation protection.

“Corporate linkers are more credit intensive and less liquid than straight bonds, so most institutions prefer to gain protection against inflation using index-linked gilts or inflation swaps. Swaps are liquid and they do not require immediate funding. Inflation swaps are an exchange of cash flows where the institution pays a predefined set of fixed cash flows in return for a series of variable inflation-linked cash flows,” says Marcus Hiseman, managing director, head of European corporate fixed-income capital markets at Morgan Stanley.

Feeling the squeeze

Since 2008, however, the swap market has become considerably quieter, not least because Basel III makes it far less attractive for banks to hold long-dated infrastructure debt.

"Swap supply is fairly limited because the main source has been from infrastructure, utility and property companies and at present there is too much pressure on bank capital to take on the credit risk that that entails," says Evan Guppy, head of UK inflation trading at HSBC.

The squeeze on bank capital has prompted fund managers to seek inflation protection in new and different ways.

“Lending banks have reduced liquidity and risk appetite to do long-term infrastructure deals. Historically, pension funds looking to source inflation would either access the inflation-linked swap market or invest in index-linked gilts. Pension funds are now beginning to think about accessing inflation via the infrastructure market directly,” says Rob Gardner, co-chief executive of investment consultancy Redington.

Bricks and mortar

Mr Gardner points to social housing as an area of potential co-operation. “Banks have significantly reduced lending, however housing associations still need money and pension funds need alternative sources of inflation. The transfer of capital could take place directly, that is, without the banks,” he suggests.

The phenomenon is not entirely new. The Ontario Teachers’ Pension Fund, for instance, has a dedicated infrastructure arm, and large North American university funds operate similar schemes. “We are in a period of flux. Pension funds need to start considering investing in infrastructure assets,” says Mr Gardner.

Ground rent has also come onto fund managers’ radar. “Ground rents have some linkage to inflation and you can buy them directly from house-builders or commercial property developers. No one thought about them a few years ago but now ground rents seem an interesting proposition,” says Mr Nicoll.

Over the past couple of years, interest in the sale and leaseback market has developed too, where property owners, such as retailers, sell freehold assets to pension funds and lease them back. The demise of care home operator Southern Cross has emphasised the need for robust due diligence in this sphere but, provided the borrower is credit-worthy, these deals provide an effective inflation hedge.

Across the pension fund community, inflation remains high on the agenda as managers seek out ways to match assets to their liabilities. A number of participants in the market believe that, while index-linked bonds from sovereigns and non-sovereigns will remain obvious sources of inflation protection, new ways are almost bound to come to the fore, chiefly those involving infrastructure.

“Pension funds are beginning to buy infrastructure directly, such as social housing. This will be an ongoing trend over the next five years,” says Mr Bell.