Although sovereign issuers have so far dominated the inflation-linked bond market, the number and diversity of issuers is beginning to grow along with the investor base.
Inflation-linked bonds – commonly known as linkers – are becoming an increasingly popular tool for investors’ strategic hedging requirements, and more big issuers are expected to enter this $450bn market in the near future. Most inflation-linked bonds are principal-indexed, that is their principal is increased by the change in inflation over a period, generally using the consumer price index (CPI) or its equivalent as an inflation proxy. As the principal amount increases with inflation, the interest rate is applied to this increased amount, causing the interest payment to increase over time. At maturity, the principal is repaid at the inflated amount, so an investor gains full inflation protection as long as the inflation rate equals the CPI.
In the beginning
“The inflation market really got started in 1997 when the US Treasury began to issue inflation-linked bonds,” says Philippe Challande, options and structured products trader at BNP Paribas. “These were called Treasury Inflation-Protected Securities (Tips), that pay a guaranteed real return. Like conventional bonds, Tips pay interest at fixed intervals and return the principal at maturity. But unlike the principal of conventional bonds, the principal of Tips is adjusted each month in step with the general price inflation as measured by the US Bureau of Labour CPI. Interest is paid twice a year and the interest rate is fixed, but the amount of each interest payment varies because the rate is applied to a principal that is changing to keep up with inflation.
“A year later, the French Treasury decided to issue its first bond, the OATi-2009, the first in Europe except for the UK, which has been issuing since the early 1980s,” says Mr Challande. “Greece and Italy came into the market with bonds issued on European inflation last year. Until then, the main European market was French inflation. Now there is talk about Germany coming in. They have been studying the product for some time and there hasn’t yet been a decision to issue, but it’s very likely to happen.”
The inflation-linked bond market grew more than 200% in volume between 2001 and 2002, and it achieved roughly the same level of growth last year compared with 2002. Analysts predict further volume growth this year and beyond, albeit at a more modest rate. The US is the biggest market with bonds valued at $176bn, followed by the UK with Ł78bn and France with E46bn. Other sovereigns that have entered the market are Sweden, Italy, Canada, Australia, Greece, Iceland and New Zealand.
Corporate interest
Sovereigns dominate the issuer side but there are likely to be more corporates coming into the market. Many of them are seen to be a little more opportunistic, in that they will potentially swap some of their issuance, something that sovereigns have not yet done to any great extent. Some of the bigger corporates that would be dipping their toes into inflation-linked bonds for the purposes of advertising may also be more interested in setting up a benchmark. If they have a benchmark programme of two years, five years and 10 years, it may be more useful for them to be credible on those benchmarks than to do a new product altogether, according to analysts. These would include utilities, public works bodies and property investment trusts, among others.
Rich Herman, European head of rates at Deutsche Bank, says one of the main reasons that inflation-linked bonds have become such a dynamic market is that issuers, as well as investors, are taking an interest in the product. “From the issuer point of view, governments are issuing inflation bonds because it gives them a stamp of credibility in terms of their monetary policy and it also fits well inasmuch as they are trying to advertise a new kind of bond after they have created a benchmark,” says Mr Herman.
New business
Mr Herman says that the investor base is growing along with the number and diversity of issuers. A lot of business is coming from pension funds that have come to realise over the past 10 to 20 years that fixed income is stable but does not meet their obligations on their guaranteed annuities. On the other hand, while equities are a positive long-term investment, it is a volatile market. For these pension funds, inflation-linked bonds are a good product to match their liabilities.
“One example was Boots Pension Fund, which last year bought Ł2.2bn of inflation-linked bonds and derivatives,” says Mr Herman. “So there is an expanding real money base, which is needed to grow the business. Then there are the intermediaries, such as hedge funds that will take a view on inflation in one country versus another. There are also intermediaries like ourselves, who will take the cash product and turn it into a derivative product, hold the risk in between for a period of time and then try to transform that risk into another interesting product.”
These buyers are looking for alternative investments because pension funds of companies in the Standard & Poor’s 500 Index lost more than $200bn on stock market investments during the three-year bear market that started in 2000. Last year’s stock market rally boosted global pension assets to $14,200bn, yet this still left a deficit of $1500bn at the end of 2003, leaving pension fund trustees more open than ever to new ideas like inflation-linked bonds.
Big buyers
Pension fund exposure is on a real and not a nominal rate, so the funds are naturally big buyers of inflation-linked products, says Mr Challande. The inflation-linked market now provides enough liquidity for the large-scale hedging programmes of these investors. Asset managers are also investing in inflation-linked bonds because they are managing portfolios for entities that need to hedge inflation, or for diversification.
“There are retail customers for short-term maturities. Pension funds are looking for long-term maturities of 10 to 30 years, retail investors are two to 10 years and insurers are in the middle, at about 10 years, while asset managers cover the whole spectrum. Meanwhile, we are seeing more corporates with inflation-linked income they can hedge and it’s often better for them to have debt linked to inflation that allows it to be more closely correlated with their income and not to be exposed to market conditions,” says Mr Challande.
Axel Röhm, investment manager at Dutch pension fund PGGM, points out two reasons why inflation-linked bonds are an attractive product. “With our liabilities linked to wage inflation, our intention is to index our pensions every year and the closest way to hedge is through price inflation,” he says. “On a hedged basis, it doesn’t make much difference if you use European inflation-linked bonds or a mix of global bonds. Second, it turned out to be a good diversification within our portfolio.”
PGGM has invested 8% of its fixed income portfolio (30% of its fund) in inflation-linked bonds, which breaks down to E680m equivalent in US Tips, E500m equivalent in UK linkers and E170m in European inflation.
“We’re certainly following this market very closely,” says Mr. Röhm. “We are doing a new asset liability manager (ALM) study this year and we’ll wait for the outcome of that to see if our benchmark [the mix of different asset classes within the fund] changes on a strategic basis.”
Fund managers have also become active buyers of inflation-linked bonds in the US and elsewhere. John Brynjolfsson, who runs the California-based $5bn Pimco Real Return Fund California, says he is “startled” by how well the bonds have performed. “The yields have evolved from being obscenely cheap to being fairly valued,” he says.
Inflation sellers
Deutsche Bank’s Mr Herman says any corporates that are trying to fund their long-term, public works or property projects that are linked to inflation, are all interesting sellers of inflation. “We [also] see more governments getting into this space. Even Japan this year is issuing Japan Government Bond i (JGBi), which is interesting because it hasn’t had inflation for such a long time. It issued its first one a few weeks ago of about Ą100bn, roughly E750m. Japan has had deflation for the past three or four years, so it is almost credibility the other way round, in that it has a credible policy of no longer having deflation,” he says.
How attractive would corporate issuers be to investors? Mr Rohm says he would welcome more diversity on the issuer side. “Corporates could enter the market either by issuing inflation-linked bonds or as inflation payers in the inflation swap market,” he says. “Both will benefit a steady development of the overall inflation-linked market. [But] any investment decision by PGGM will depend on a careful analysis of the credit spread and the liquidity of inflation-linked credits.”
