Geraldine Lambe examines the reasons behind inflation-linked securities’ increasing popularity and asks why more corporates have so far not seen the benefit of diversifying their debt strategy.

It may seem ironic at a time when many economies are under pressure from disinflation, if not deflation, that inflation-linked securities should step into the spotlight. But according to AXA Investment Management, in the last year, they outperformed against equities and provided higher returns than nominal government bonds.

Issuance figures are increasing and the yield curve is becoming enriched. Today there are more than E350bn of inflation-linked government bonds – or linkers – outstanding globally. Barclays Capital estimates that the market has the potential to rise to E1000bn by the end of the decade.

In February, the French debt agency, Agence France Tresor, a key issuer against both French and eurozone inflation, was able to launch a new product directly through auction, the E4.5bn 10-year French OATi – proof, if proof were needed, of how the market is maturing. And a new issuer joined the fold when the Greek Public Debt Management Agency brought its first index-linked product to the market in March.

No-one believes that governments or central banks will allow deflationary pressures to continue, so it makes sense for investors to protect at least a proportion of their assets against inflation. For issuers, the key drivers are to match assets and liabilities, and diversify their debt strategy, as well as to appeal to a broader investor base. Nonetheless, the market is dominated by a handful of sovereign issuers and there is little corporate participation. Equally, linkers still represent only a small chunk of outstanding debt. In the US last year, they represented 25% of the annual 10-year note issuance, but overall, they account for 4.7% of the $3000bn marketable treasury debt outstanding.

Political decisions

The breadth of the sovereign market is determined in part by a balance of political will and borrowing needs. There are a lot of stakeholders in government debt and the decision to use inflation-linked products can go all the way to parliament.

In emerging markets, where the risk of inflation is high, linkers can be a useful way to persuade reluctant investors to buy government debt by showing that the government is committed to controlling inflation. But in countries where investors are already willing to put their money, the added cost of the inflation risk premium can serve as a disincentive. “Why issue a [more expensive] inflation-linked product when you expect inflation and can already place your bonds,” says one market participant at a US investment bank.

Borrowing requirements are also crucial. Smaller countries with limited borrowing needs are unlikely to build a yield curve in the same way as France, the UK or the US, because their priority is to encourage investor interest by providing deep liquidity with a single benchmark issue.

Lack of liquidity has also played a key role in preventing the market from growing at a faster pace. Sylvain de Forges is CEO of Agence France Tresor, which intends to increase linkers as a percentage of the country’s debt from 5% to 10% in the next years. He says: “We need other issuers to help develop the overall liquidity of the market. It is good to see Greece coming into play.”

Sylavain de Forges: 'There has to be balanced interest - from the buy side as well as the issuers'

Market making

Mr de Forges says it is up to primary dealers who are active in these specific products – the numbers of which have blossomed from only two or three a few years ago to around 15 – to build the market by selling the benefits to issuers and investors. “There has to be balanced interest – from the buy side as well as the issuers,” he says.

But it is investor behaviour, too, that is contributing to the market’s illiquidity, and that can make linkers a more tricky sell to both the issuer and the investor. At the moment, there is a limited pool of investors. Patrick Van Der Wansem, vice-president of sovereign origination at JP Morgan, says that new participants are waiting for the market to deepen before they dip their toes in. “Some Dutch pension funds are keen to invest up to 15% of their portfolios to inflation-linked products but want the market to be bigger and more liquid before they commit to it,” he says.

Patrick Van Der Wansem; ‘It is taking corporates a little longer to see the benefits of diversifying their debt portfolios’

Adding to linkers’ liquidity woes, Mr Van Der Wansem says that while traditional bonds trade quite heavily in the secondary market, investors in the inflation-linked market tend to buy and hold, so at the moment they are just absorbing the supply. “But as the market matures, more investors will begin to trade on their relative value and the liquidity will build,” he says.

According to John Brinjolfsson, managing director at Pimco Investment Management, that may already be happening. He says there is an increasing trend for investors to use inflation-linked notes for tactical reasons – as a short-term substitute for treasuries or fixed-rate bonds – as well as for strategic reasons based on the long-term needs of fund beneficiaries. “US 10-year treasury yields are currently 3.17, while 10-year inflation-linked treasury note yields are 1.36, with a difference of 1.81. That means that if inflation is higher than 1.81 over the next 10 years, even fixed rate treasury holders would have been better off with inflation-linked bonds.”

But, in the chicken and egg situation of building liquidity to encourage more issuers and investors to the marketplace, many believe that the pension reforms being discussed by many governments may go a long way to deepening institutional interest. “When actuaries begin to recommend that fund managers increase their holding of inflation-linked instruments to meet their long-term target real returns, it will help to build the investor community,” says Jorge Garayo, European fixed income strategist at JP Morgan.

However, in many countries, the pension funding requirement is a political football that is still being kicked around. In the UK, the government has said it will scrap the minimum funding requirements in the next year – blaming them for an exodus from equities to bonds – to be replaced by a scheme-specific funding requirement. “But nobody knows precisely what this means, despite many consultations,” says one actuarial consultant. “It is simply a way for the government to avoid taking the blame if it goes wrong.” The UK government is also moving to a US-type model of pension scheme insurance.

How the new funding requirement is implemented will affect the pension schemes’ appetite for risk, as will the presence of an insurance safety net. “The more risk that pension funds feel they can take, the less likely they will be to allocate significant proportions of their portfolios to inflation-linked bonds,” says Tim Gordon, a member of the Pensions Board at the UK’s Faculty and Institute of Actuaries.

Issuers may still look to pension funds to broaden their investor base, though, as shifting demographics are steering some pension funds towards a greater exposure to index-related products.

“Pension schemes are maturing [as well as defined benefit schemes being closed to new entrants] and this brings asset-liability management to the fore. As the average age of members increases, funds will need to match investments and liabilities more closely, so this trend may steer them towards a greater allocation to inflation-linked products,” says Mr de Forges.

Corporate culture

Corporates, so far, have largely ignored the inflation-linked market, despite its potential to diversify debt strategy and enhance asset-liability management. In part, this is because linkers are most attractive to those corporates with revenue streams that are tightly correlated with consumer price indices. Thus, at the moment, corporate issuers are mainly drawn from the ranks of energy and power firms, water utilities and rail operators.

Mr Van Der Wansem says that many corporates are more focused on cost and credit spreads and, for now, less on the risk management advantages that linkers can offer. “It is taking them a little longer to see the benefits of diversifying their debt portfolios,” he says.

One corporate treasurer agrees: “When corporates project their future revenues, many are not so convinced that they will be closely linked to inflation. Also, individual pricing power and technological innovation are very important in their calculations, so inflation may not their major preoccupation,” he says.

Ideal industries

There are industries, however, in which linkers would be a highly appropriate part of a firm’s debt strategy, particularly those that have to finance very long-term developments, such as telcos. But they have not been enticed into the marketplace yet.

According to Fred Cleary, interest rate strategist at Barclays Capital, a government issuer is generally needed to establish the market, with corporates issuing when the market appetite is such that the cost of issuance meets their requirements. In the US, for example, the treasury is taking on the short-term cost of lower implied inflation risk premiums to create a market and to build liquidity, says Mr Cleary. Corporates will become more active when investor demand begins to exceed government supply. However, corporates may be encouraged into the market if they need to reduce the inflation exposure from a balance sheet perspective.

“Generally speaking, corporates need a relatively high-level of break-even before they will look to establish an inflation-linked programme, if it is simply for alternative funding,” says Mr Cleary.

“TIIPs [US treasury inflation-indexed securities] have traded historically cheap with respect to actual inflation out-turns, which is discouraging from an issuer standpoint. In the US, 10-year break-even spreads are just under 1.6% – well below consensus expectations. We therefore need to move up to a level that more accurately reflects the risk premium, then corporate issuance will pick up.”

That said, Mr Cleary argues that a prime driver should be the benefits of asset-liability management and that the absolute level of break-even spreads should not deter corporates from issuance. “They should scale their issuance with respect to the probability of inflation being below the break-even they can achieve by issuing,” he says.

Fred Cleary: ‘We need to move up to a level that more accurately reflects the risk premium’

Risk management

Mr Brinjolfsson says that this sort of asset liability management is simply good risk management, particularly for corporates with pro-cyclical businesses. “In a downturn, fixed rate bonds are very onerous for corporates. If they had issued a proportion of inflation-linked notes, their liabilities would have declined in line with the economy. While payments are more costly when the economy is robust and inflation is rising, they should be in a better position to meet those sorts of payments,” he says.

Even if corporates still see inflation-linked securities as a juvenile asset class and have been put off by relatively small investor base, most believe that they will be quicker to build a yield curve than sovereigns, once they get going. This is in part because they are increasingly looking to be more active in their portfolio management, says Mr Van Der Wansem. “They are now asking how they should manage their portfolios, not just how do they raise money,” he says.

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