Italy's entry into the euro zone inflation-linked market alongside France and Greece has demonstrated insatiable demand for the product. Rather than buckle under the weight of supply, the market has thrived and DCM bankers are seeking out new candidates. So far non-government supply has been limited to structured MTNs, but greater liquidity in the swap market could boost issuance of inflation-linked bonds. Neil Day reports.
The capacity of the inflation-linked market in Europe has nowhere been more amply demonstrated than in the issuance of the Republic of Italy since last autumn. Before then the country had never issued an inflation-linked bond. Today, it has over Eu21bn of inflation-linked paper outstanding.
Italy entered the market with a bang in September, its inaugural linker reaching a giant Eu7bn, making it larger even than any syndicated nominal government bond. Led by Banca IMI, MCC Capitalia and Morgan Stanley, the deal attracted some Eu11.5bn of orders, tapping into both domestic and international demand.
"Demand from Italy was very strong," says Gideon Gent, head of syndicate at Banca IMI in Milan. "We sold tickets to a wide range of accounts, including mutual funds, insurance companies and banks."
International buying was also high. "Demand was strong from areas with a longer history of buying inflation-linked products and experience of taking a view on different inflation rates," says Giles Hutson, syndicate manager at Morgan Stanley in London.
Such buying enabled Italy to twice increase the transaction, firstly in October by Eu3.15bn, and then in March this year by Eu3.25bn, taking the issue to Eu13.4bn. The deal was followed by a 10 year issue in February. Led by Barclays Capital, BNP Paribas, Citigroup, Goldman Sachs and UniCredit Banca Mobiliare, the transaction was then increased by Eu3.5bn in April.
Although these volumes have been impressive, Maria Cannata, director general of public debt management at the Italian treasury in Rome, says that she was confident the product would be well received. "We have not been too surprised by the amount we have been able to raise," she says, "because before we launched the first transaction we were convinced that there was strong demand for inflation-linked bonds. The first transaction showed that we were right and subsequent issues have confirmed how much interest there is in our inflation-linked paper."
As well as the advantage of diversifying Italy's investor base, Cannata says that the issuance of inflation-linked bonds gives the sovereign the opportunity to reduce the pressure on its nominal market.
Having launched over Eu11bn already this year, Cannata says that between Eu15bn and Eu20bn of inflation-linked supply is likely from Italy by year end. However, she says that the republic will issue in response to demand and will not overburden the market with supply.
"We will be quite prudent in the amount we issue," says Cannata. "We are quite flexible at the moment because we are new to this market and are therefore not so constrained in what we do. But in the future we will not increase excessively the percentage of this product in our total debt."
For the time being, Italy will also focus on the short to medium part of the curve where it has already issued. "We are studying possibilities at the long end, but we have not yet come to any decision," says Cannata. "There are some signs that there is demand there, but we are not convinced of the stability of this demand. While it may be there now, we would prefer to wait until we are confident that it will be more persistent."
Greece, France boost supply
The Hellenic Republic's profile in the inflation-linked market was raised in January when the sovereign increased its Eu1.25bn 2025 euro zone inflation-linked bond by Eu1.75bn. Led by BNP Paribas, Commercial Bank of Greece and Morgan Stanley, the increase took the size to Eu3bn and made the deal eligible for trading on the MTS platform.
Since then the transaction has been increased by a further Eu400m, taking it to Eu3.4bn, and over the next year, says Christoforos Sardelis, director general of the Greek public debt management agency, the deal should reach Eu5bn. "The transaction now has a 21 year maturity," he says. "When we launched it last April we intentionally made it a 22 year deal as I promised the market to return with re-openings in 2004 and 2005.
"Depending on demand later this year, we could do a small re-opening, and then we will be back in the market next year to take the total size over Eu5bn. Next year, it will be a 20 year benchmark."
Like Italy, Greece has chosen the euro zone inflation measure rather than a domestic one. "The intention of this inflation-linked issue was to satisfy European rather than domestic demand, and those accounts are looking for euro zone linkers," says Sardelis. "We have seen funds in Greece buying this paper, but the majority of demand comes from abroad."
The French government, which got the euro zone inflation party started in October 2001, in January filled out the real yield market with the launch of OATei to fill the 15 year part of the curve. The Eu4bn July 2020 deal, led by BNP Paribas, Deutsche Bank, Goldman Sachs and SG, attracted Eu5.5bn of demand, meriting an increase from Eu3bn.
The choice of the 15 year maturity was seen as being partly prompted by Italy's five year issue, since before that deal officials at Agence France Trésor (AFT) had indicated that the main candidates for a new line were the five and 15 year maturities.
Bertrand de Mazières, chief executive of AFT, says that he is pleased to see more countries joining the market. "We welcome these issuers because it is a very good indication that the market is developing well," he says. "It is also better not to be the only one issuing any category of asset and investors like to see more than one issuer offering a product."
For France, says de Mazières, one of the biggest effects of its inflation-linked issuance has been the diversification of its investor base. "At the end of 2003, non-resident investors held 42% of all French debt," he says, "but for linkers the share is much higher. If you look at the order book for the 2020, around 60% of it was non-French, and in the previous two linkers the French share was only one-third."
The maturity of the OATi and OATei markets is illustrated by the way in which issuance has become smoother. Last year AFT for the first time auctioned a new line, the OATi 2013, and this year a specific auction timetable for linkers has been established, with sales on the third Thursday of every month.
France now has some 7% of its debt in inflation-linked bonds. De Mazières says that there is room for further growth, albeit modest. "We are at a level where we can comfortably increase the proportion further, towards 10%, but beyond that we would need to investigate more closely the impact of such issuance."
Hedging their bets
As well as the benefits of investor diversification and a new funding tool, inflation-linked bonds are seen by many observers as offering sovereigns a means of hedging their debt servicing costs against their revenues. "The sovereign is the natural issuer of inflation-linked debt because there is a correlation between the expenditure side and the revenue side," says Cannata at the Italian treasury.
However, not everyone has yet been convinced of this argument for inflation-linked issuance. Erik Wilders, head of money and capital markets at the Dutch State Treasury Agency, says that while he welcomes the development of an inflation-linked market, the advantages of linkers to the sovereign are not persuasive.
"The DTSA presently has no intention of issuing inflation-linked bonds," he says, "but it is good to observe that the market is growing and becoming more mature, because the increased issuance by other sovereigns helps promote liquidity and efficient pricing, which will facilitate our further investigations into the product.
"Until now, when comparing the history of the product with a combination of bills and bonds such that our annual budgetary risk is the same as with an inflation-linked bond, what we see is that inflation-linked bonds have been more expensive than the combination of bills and bonds."
Part of the reason for this is the way in which the inflation element of linkers introduces uncertainty to the product in the same way that short dated or floating paper carries refinancing or reset risk.
But some analysts argue that the apparent risk of volatility in inflation should not be such a concern. "There is a direct link between inflation and government revenues, with higher inflation feeding into higher revenues through income taxes and VAT," says one.
"In the event of inflation, government revenues would therefore rise and that would make it easier for them to service their debt. From a risk management perspective the two sides are matched and the possibility of higher inflation is therefore not something that should dissuade governments from launching inflation-linked bonds."
This, he argues, has been understood by the German finance agency, which is said to have been won over to the product. "They were not able to include inflation-linked issuance in the last budget because of time constraints," he says, "but we expect them to enter the market as the benefits to them are clear.
"If Germany had begun issuing inflation -linked bonds at the same time as France, in 1999, then they would have been issuing with a breakeven scenario of around 2%, so basically the real rate on the inflation-linked debt would have been 2% below the nominal rate on their debt. If it had been linked to domestic inflation, then Germany's debt service costs would have been 1% lower because inflation is running at around 1%. And if all German debt had been inflation-linked, the country could have avoided breaching the Maastricht criteria."
A limited number of non-sovereign issuers have also recognised the benefits of having liabilities linked to inflation when their revenue streams are similarly linked. Infrastrutture, the Italian infrastructure agency, included Eu750m of bonds linked to domestic inflation when raising Eu5bn in January to finance the country's new high speed railway. Cashflows from track access charges to be paid by train operators using the new network are linked to inflation.
Réseau Ferré de France (RFF), which maintains the French rail network, is an established player in the inflation-linked market and in March increased its 2023 euro zone inflation-linked issue from Eu800m to Eu1.4bn via BNP Paribas, Credit Suisse First Boston and SG.
The issue for the triple-A agency was originally launched in February 2003 and was the first non-government bond linked to euro zone inflation. Part of RFF's balance sheet is linked to inflation so the issuer had long been seen as a potential candidate for the product, especially since its agency credentials would enable it to sit easily alongside French sovereign inflation-linked paper.
Pierre Fourrier, head of the finance department at RFF, says that while the agency is keen to continue accessing the inflation-linked market, it is under no pressure to do so. "We do not have a target for the amount we want to raise in inflation-linked debt," he says, "so when we issue this type of bond, it is in response to demand." Fourrier says that the maximum amount that RFF is likely to issue in inflation-linked bonds is around 10% of its outstanding debt of Eu24bn.
Further non-central government candidates for issuance are considered to be other issuers with inflation-linked exposure on their asset or revenue side. "One could imagine that utilities, municipalities or agencies with income that is quite closely related to inflation could come to the market over time, once the sovereigns have established a framework of benchmarks," says James Garvey, head of the European frequent borrowers group at Goldman Sachs in London.
But many market participants point out that issuance beyond this category of borrower is for the time being constrained by a lack of liquidity in the swaps and derivatives markets for inflation.
"Derivatives are for the time being rather illiquid for longer dated maturities," says one issuer with an interest in inflation-linked product. "There are some flows out to 10 years, but it is still quite illiquid and the transparency of prices is very low. There are no clear quotations on independent pages so you cannot reprice such exposure on a daily basis and meet internal controls.
The situation is, however, improving. Georges Elhedery, senior exotic and inflation trader at Goldman Sachs in London, says that several factors point to a rise in liquidity. "Firstly, you only have to look at the amount of MTN issuance linked to inflation that is being done," he says. "There was a tremendous increase in the volumes of inflation-linked issuance in 2003 and 2004 is bound to be a very good year."
Secondly, says Elhedery, the swap market is growing. "It is hard to get a clear picture of volumes, but if you look at the sizes that are being traded by the inter-dealer brokers, then you can see that there has been a huge increase in volumes," he says.
Thirdly, he says, bid/offer spreads have come down. Some swap candidates complain of 25bp-30bp spreads at the long end of the curve, but, according to Elhedery, the situation is much better in shorter areas. "For some maturities," he says, "like five or 10 years, the bid/offer spread is much tighter, less than 5bp."
Elhedery does, however, acknowledge that prices may not always be as readily available to investors or issuers as they are to banks, but he expects this to change. "My guess is that it will not be too long before we are in a situation where they will be able to pull information off the screen," he says. "The market has already developed quickly over the last two years, so we will get there."
Meanwhile the focus of inflation-linked MTN issuance has been Italy, where retail targeted trades took off in the first quarter of 2003 - which was also one of the factors that is said to have persuaded the Republic of Italy to enter the market.
One of the most regular participants in inflation-linked issuance in the private placement market has been the European Investment Bank (EIB), which has launched nine inflation-linked MTN trades in euros wtih a combined value exceeding Eu1bn. "We were very active in 2003," says Carlos Ferreira da Silva, head of euro funding at the EIB. "Our issues met with very strong demand, particularly in southern Europe."
The supranational has experience of issuing inflation-linked bonds in the sterling market, where it has 10 lines totalling £1bn outstanding. The majority of these, however, have been back-to-back issues to finance public-private partnership (PPP) projects that have cashflows linked to inflation.
The EIB will continue to be active in inflation-linked in sterling, since it has a pipeline of projects underway, but the process of exploring back-to-back issuance in euros has yet to bear fruit. This means that the supranational's euro-denominated inflation-linked issuance will remain of the structured MTN variety for the time being.
However, as governments across Europe seek new ways to fund projects, it is likely that the time when unswapped back-to-back issues in euros are a possibility is not too far away.