The inflation-linked bond market in Europe took a big step forward in March when Germany launched its first linker. The Eu5.5bn deal not only added Europe's premier issuer to the market, but gave many investors in Germany and elsewhere confidence to start buying the product. As Neil Day reports, inflation has come to the forefront of investors' minds in recent weeks, which is likely to help the market's development.
Inflation in the US hit the headlines in a big way in mid-May, causing shockwaves that ran around the global financial markets.
In the euro zone the subject has come to the fore gradually, over a longer period, but now that markets are reacting to US inflation, continental Europe is paying renewed attention to it.
"Inflation is a buzzword again," wrote analysts at Dresdner Kleinwort Wasserstein at the beginning of a recent research piece on the inflation-linked bond market.
The implication for inflation-linked debt is that it should become more attractive to investors. "There is clearly a chance that with commodity prices being high and in general inflationary pressures building, investors will be looking more closely at instruments that protect their purchasing power," says one head of asset allocation at an investment manager in London.
The economic background could hardly be more ripe for the recent broadening of the market for inflation-linked bonds issued by supranational, sovereign and agency borrowers.
The most notable of these was the Federal Republic of Germany's first inflation-linked Bund, issued in early March. "Sometimes you get supply leading demand and sometimes demand leading supply, and this has definitely been a case of the former," says one portfolio manager in London. "It is a virtuous circle and we were very happy to see Germany embrace inflation-linked bonds."
The sleeping giant wakes
Germany embraced inflation-linked debt in two senses — the government decided to issue it, but perhaps just as important, the deal prompted many German investors to begin buying linkers.
The Eu5.5bn 10 year transaction, led by ABN Amro, Barclays Capital, BNP Paribas and Deutsche Bank, attracted almost 70 orders from Germany, encompassing investors from institutions to savings banks and retail. They bought 16% of the bonds.
"The Germany deal was interesting and a very important trade for the market partly because German investors had not traditionally been a mainstay of the inflation-linked market and they were able to sell a substantial amount to such accounts," says Chris Lees, head of frequent borrower syndicate at Citigroup in London. "The deal was therefore a major step in developing that investor base and will help the development of the linker market, not only for Germany, but for other issuers, too."
Others agree. "There were a lot of total return-type guys interested in the deal," says one debt capital markets (DCM) official in London, "but more important was quite a big participation from Germany — a lot of retail, but also institutional accounts.
"So there is now another big investor base from that country that is interested in this segment. And in a few months, certainly this year or next, they are going to start switching out of Germany and actively trade this segment with the other countries that are participating already."
The level of domestic participation surprised even Germany's Finanzagentur. "We did not have any specific targets regarding German distribution, but it was a pleasant surprise to see this level of participation from German investors," Andreas Ricker, head of strategy at the Finanzagentur, told EuroWeek. "We had thought it would be a little lower, maybe 10%."
And he agreed that this was not only to Germany's benefit. "It is also good for the inflation-linked market as a whole," he added, "opening a new investor group that perhaps wanted to wait for the first Bund before entering the market, and will now be open to the sector as a whole."
The transaction also inspired new investors outside Germany to start buying the product. Bankers say some of these investors had not previously felt comfortable buying inflation-linked bonds because they considered Germany the euro zone benchmark and would only buy the instruments once Germany had, in the words of one syndicate manager, given the product "its blessing".
Inflation yields real benefits
The new deal has also enjoyed almost automatic demand from existing inflation-linked investors. "There was some demand for the very simple and technical reason that a lot of index-trackers imply have to buy this issue," said one head of public sector origination in London. "Many have done so in the primary market and others will do so in the secondary market when the monthly index changes come into force, at the end of March. That gave the deal good support."
This bodes well for what is expected to be a growing Bund linker market. "Looking across euro activity this year, it is clear that one potential growth market is the linker market," says Sean Taor, head of frequent borrower syndicate at Barclays Capital in London. "Germany have said that their aim is now to increase the liquidity of that deal to an issue size of Eu10bn-Eu15bn, and potentially look at new lines as well, whether that be shorter down the curve or further up the curve."
The attractions for Germany of adding inflation-linked debt to its portfolio are several. "Firstly, as part of our overall debt management we want to expand our toolbox to have more financing instruments," said Ricker at the Finanzagentur. "We started this with the dollar benchmark and the linker gives us another option.
"Secondly, we are always trying to broaden our investor base and through the linker there is the potential for us to reach investors that are not involved in Bunds at all, or not involved as much as we believe they could be."
Equally important for Germany were the deal's effects on its funding cost, risk diversification and other risks, added Ricker. "We have crunched the numbers and this new market segment gives us a very positive diversification effect," he said.
Apart from Germany, all the sovereign inflation-linked bonds this year have come from established issuers. The Hellenic Republic increased its Eu5.2bn July 2025 euro inflation-linker by Eu2bn in early April via Banca IMI, BNP Paribas, ING and Société Générale.
Later that month France created a new July 2010 BTANei, through an auction.
Auction taps of outstanding inflation-linked government bonds have added further supply, while the Republic of Italy is expected to bring a new issue now that its elections are out of the way.
Others are said to be weighing up the benefits of participating in the market. "They have inflation-linked assets or revenues, so an inflation-linked bond is prudent asset-liability management," says one DCM official in London, "and it offers a relatively diverse investor base compared to the nominal market. With demand for linkers having grown so much, more sovereigns are clearly looking at the market, so it could see continued growth."
A linker for all seasons
One of the less obviously interesting choices the Federal Republic had to make was which month to choose as the maturity date for its Bund linker. However, this was important as it would set a precedent for future German inflation-linked issues, as well as for more technical reasons.
"The OATeis have a July maturity and because of the three month lag in inflation data, are influenced by the April inflation figures," explained a syndicate official at one of the leads. "The German linker with its April maturity — which puts it halfway between the nominal Bund months of January and July — is influenced by the January inflation figures. These are normally depressed by the January sales, so there is a distortion between the German and French issues as a result of this seasonality."
Before Germany's entrance, seasonality had not been widely discussed. This was because Italy chose a September maturity for its inflation-linked issuance, and there is usually little difference between this month's numbers and July, which Greece also uses for its linkers.
Bankers therefore forecast that this would be an increasingly high profile aspect of the inflation-linked market, and it has proven to be so. Even the difference between the July and September seasonality has come into focus.
"There has been an increasing focus on seasonality since the launch of the DBRei 16 and the BTANei 10," said analysts at Barclays Capital in mid-May.
"The BTPei 10 stands out as rich versus surrounding issues, given its poor seasonality. Our analysis, based on comparisons of BTPei 10 versus BTANei 10, and DBRei 16 versus OATei 15, suggests that seasonality is not being priced in consistently."
While this observation might imply that seasonality has yet to become a key factor for investors when pricing inflation-linked issues, there are other issues that need to be considered when valuing linkers.
"We believe that issues related to liquidity premium and supply fears might be factors behind this inconsistency," said the Barclays analysts. "The BTPei 10 might have a liquidity premium relative to the BTANei 10, which is a newer linker."
The analysts also said supply expectations might have depressed the price of the BTANei 10, as the market had been expecting it to be reopened. However, when the French government announced its plans for linker issuance on May 12, no reopening was announced.
The analysts spotted similar dynamics affecting pricing further along the curve. "Liquidity premium and supply pressure might be in favour of the OATei 15 versus the DBRei 16," they said. "It is understandable that liquidity premia might have increased, given the recent increase in the volatility in euro and other markets."
Coveting the familiar
Another factor to take into account is that investors have so far shown loyalty towards their home markets. In some cases this has been by choice, but in other cases, such as France, it has been the result of constraints on some inflation-linked investors.
Benoît Coeuré, deputy chief executive officer of Agence France Trésor in Paris, says such demand has been a significant element of the bid for its OATi deals, linked to inflation in France, as opposed to the euro area. "We continue to see strong demand for French linkers as a result of the Livret A regulation, the regulated savings accounts," he says. Some French savings accounts are 50% indexed to French inflation.
One investor says this concentrated demand can push down the part of the yield curve at which it is directed.
"Short dated yields are pretty low, as some of the bonds in shorter maturities have been heavily bought by the French accounts in relation to their indexation obligations," says the fund manager in London.