The boom in inflation-linked activity is impossible to ignore. Issuers are rushing to take advantage of an explosion of demand, investment managers are seeking mandates in the product, and banks are relishing the new markets. EuroWeek looks into the motives driving funds into the asset class. In the next section, on page three, the strategies of issuers hoping to tap into inflation-linked flows are examined. Neil Day reports.
When the Japanese government in January announced its intention to launch its first inflation-linked bond, the news surprised onlookers. "Surely deflation, not inflation, is what investors need protection from?" was a common question. And the Bank of Japan's latest report on the outlook for consumer prices hardly appeared to argue in favour of such a product.
"The year-on-year rate of change is likely to be around 0% for the time being, due partly to the rise in rice prices," the report said. "However, they are basically projected to continue falling slightly, since the imbalance between supply and demand in the economy still remains considerable, despite its gradual improvement."
Yet when the first Japanese government inflation-linked bond was auctioned at the beginning of March, investors leapt at the chance to buy the issue. The government sold ¥100bn of 10 year paper after orders topped ¥480bn.
Part of the reason for the strong interest in the transaction was clearly the perception that after six years of falling prices, deflation appeared likely to end - growth in Japan was at its fastest for 13 years in the fourth quarter of 2003, at 7%, and forecasts of growth in 2004 and 2005 ranged from 1.5%-2.5% at the time of the bond.
However, analysts pointed out that rather than any sudden short term change in outlook, more profound considerations were driving investors towards the new instruments.
"It is naive to believe that investors do not require hedging instruments against future inflation risk, just because the economy is currently in a deflationary environment," said one. "Pension companies have inflation liabilities, and they like to hedge themselves with instruments sensitive to inflation. Traditionally this has been through equities, but in the past few years in Japan the equity market has been moribund, and inflation-linked notes provide a more accurate means."
The government, meanwhile, was seen to be basing its actions on more obvious motives. "The Japanese government has a huge amount of debt it needs to raise and roll over, so the Ministry of Finance needs to access as many funding alternatives as possible," said the analyst.
Issuers get real
Japan's decision to launch an inflation-linked bond and the market's enthusiastic reception offer an extreme example of trends that are being witnessed across the globe. For all the talk of deflation stalking the world economy in recent years, inflation has become the hot topic in the global bond markets.
"It is a very interesting time," says Mark Parry, director, inflation-linked bonds at Schroders in London. "Originally it was high inflation countries that started issuing inflation-linked bonds, but we are now seeing countries at the other end of the spectrum. Japan, traditionally the lowest inflation country, entered the market this year, and Germany and Switzerland are talking about such issuance, too."
Meanwhile activity in established markets, such as the US, is picking up. Having created its Treasury Inflation-Indexed Securities product, commonly known as Tips, in 1997, the US Treasury has introduced more regular issuance and considered expanding the range of maturities available. And while opportunistic holdings of Tips have made up the majority of investments in inflation-linked products, the number of accounts dedicated to the product is growing rapidly, say US fund managers.
The pick-up in activity in the US was also demonstrated by a rare non-government inflation-linked bond from Fannie Mae in February. The US agency's deal, led by Deutsche Bank, was increased from $500m to $750m, and although follow-up supply has not been forthcoming, bankers say the potential for similar issuance has increased.
In Europe the boom in inflation-linked activity has been impossible to ignore. With France having set the stage for a euro zone linker market with the creation of its OATei product, the past 12 months have seen a tremendous growth in issuance.
The Hellenic Republic entered the market with its inaugural deal in March 2003, a Eu1.25bn 2025 issue via JP Morgan, National Bank of Greece and UBS Warburg, and followed that up with a larger Eu1.75bn increase in January, with BNP Paribas, Commercial Bank of Greece, Goldman Sachs and Morgan Stanley at the helm.
The Republic of Italy then took euro zone inflation-linked issuance to a new level by entering the market with a Eu7bn five year BTPei in September last year. Led by Banca IMI, MCC Capitalia and Morgan Stanley, the issue was also the largest ever syndicated government bond. The sovereign has since added Eu6.4bn to the issue and in February launched a Eu5bn 10 year BTPei via Barclays Capital, BNP Paribas, Citigroup, Goldman Sachs and UniCredit Banca Mobiliare.
A match made in heaven
Even in the UK - where the index-linked Gilt market is the oldest modern inflation-linked market, having been established in 1981 - the product is enjoying a renaissance.
"In the UK we are seeing a big shift into index-linked bonds," says Peter Day, head of single currency fixed income portfolio management at Barclays Global Investors (BGI) in London. "Pension funds have become far more acutely aware of the mismatch between the assets and the liabilities that they face, so they are looking at opportunities to increase their exposure to inflation, either through buying index-linked governments, inflation-linked corporate bonds or by using inflation-linked swaps."
Tim Peat, managing director and global inflation-linked product co-ordinator at Barclays Capital in London, says that the product is now receiving the attention that it deserves. "We've been involved in the UK market since its inception in 1981 and we have always felt that it was an asset class that was under-recognised," he says. "But we have been pleased to see that since the bursting of the equity bubble in 2000, and the big changes in matching pension assets and liabilities that followed, the product is receiving the attention it merits from issuers and investors alike."
Peat says that it is ironic how the instrument began to grow in popularity in a period when inflation expectations were subdued, but he says that it is important not to be simplistic in one's approach to the product.
"We don't only argue in favour of inflation-linked bonds on the basis that they are going to protect you from inflation," says Peat. "That is clearly a very important long term benefit of inflation-linked securities because they do preserve your real purchasing power. But they are also a very important diversification asset away from both equities and bonds."
And Peat says that recent experience and the prevailing conditions in equity and bond markets have allowed the strengths of inflation-linked bonds to come through.
"Their return characteristics are no longer as far removed from people's expectations of alternatives such as equities, where investors were looking for double-digit returns for some time," he says. "Now you have very much got single-digit expectations in both nominal bonds and equities, and inflation-linked securities can manage returns like that quite easily as well, but with far lower volatility of return This feature makes them very attractive to investors who are now more risk averse. It also means that you know you are not going to lose your shirt by investing in inflation-linked bonds, and the mere fact that they are unexciting is quite exciting."
At Schroders, Parry, who is active in inflation-linked markets around the world, supports Peat's views. "If you have inflation-linked liabilities, then the only perfectly correlated, perfectly matched asset for that is going to be an inflation-linked bond," he says. "You can buy real estate and it might work. You can buy equities and it might work. But the only way that you can guarantee matching your cashflows effectively is by buying a bond that meets those cashflows, and that is where inflation-linked bonds come in."
Alongside this argument for the asset class, Parry also believes that prevailing economic fundamentals recommend the product. "As well as the question of whether or not one might want to own inflation-linked bonds generally, there is also, of course, the question of whether or not to own them right now," he says. "This is an environment where if there is a policy risk globally, it is of more, rather than less inflation. It is therefore probably a time when you would be more interested in protecting your portfolio against that."
Ivan Skobstov, an inflation-linked fund manager at Pimco in Munich, meanwhile, says that there is a long term event in favour of holding inflation-linked bonds. "Continental Europe is facing a massive demographic crisis," he says.
With their ageing populations, lack of private pension provision, and reliance on pay-as-you-go systems, Europe's continental economies are expected to face ballooning deficits. "It is almost guaranteed that there will be a secular economic crunch in 10-20 years' time and governments will be tempted to inflate their way out of explicit and implicit debt," says Skobtsov.
In the short term, however, other investors feel that there is little value in European inflation-linked bonds based on economic fundamentals. "We are not particularly positive on inflation-linked bond markets at the moment on a relative value basis," says Day at BGI, who manages a range of fundsd primarily invested in sterling index-linked, but which can trade other inflation-linked markets. "Our rationale is that breakeven inflation rates in the UK, and in other markets as well, are some way above long term inflation expectations.
"In the UK we have got breakeven inflation above 3% and long term inflation expectations are probably closer to 2.75%. In euros breakeven inflation rates are around 2.2%, which is considerably higher than inflation expectations. The implication of that is that if you hold index-linked bonds over the long run then you are likely to see underperformance relative to holding nominal bonds, so we think that inflation-linked bonds appear expensive."
Day is, at the same time, aware that alongside economic fundamentals other factors are at work. "Having said that, we would be cautious about being too underweight inflation-linked bonds," he says. "The reason for that is really the structural buying of more inflation-linked assets by pension funds.
"At the moment pension funds are reappraising their optimal asset allocation and are massively increasing their allocations into inflation-linked to reduce their asset-liability mismatch. Often demand of this kind is not particularly price sensitive. As a consequence, we are mindful that in the short term the structural buying that is underway could mean that inflation-linked markets actually get to even more expensive levels."
The parallel growth in issuance of and investment in inflation-linked products has created new opportunities for fund managers. Schroders, for example, established one of the first global inflation bond funds in November.
"It has only been in the last few months that we have had the investment universe available to allow us to invest truly globally," says Parry.
"By that I mean a full yield curve in each of the currency blocs. Only this year have we had a French issue to fill out the middle of the yield curve, rather than the two previous distinct points. We have also seen new and increased issues from the Italian and Greek governments."
Fund managers such as Day at BGI have also seen their options widen. Growth in the US or euro zone inflation markets has provided him with new opportunities that he can take advantage of. He is also looking forward to the time when Japanese inflation-linked bonds are made available to international investors.
But while not denying that the growth of the inflation-linked market has been impressive, some market participants caution that in some areas the product is taking longer to make an impact.
"It is taking time for the asset class to work its way into policy allocations because sponsors tend to be a little behind the curve," says one euro zone fund manager. "That may be for good reason - because they have their fiduciary responsibilities and they perceive new asset classes as risky - but it will nevertheless inhibit the speed at which the market grows. Interest is definitely growing, but it is more in the form of information gathering rather than outright mandates."
And while few observers would dispute the need for changes to the way pensions are funded in Europe, many obstacles lie on the road to reform. Skobtsov at Pimco, for example, warns that the short time horizons of politicians will hold back the pace of reform. Others are also cautious.
"We shouldn't get too excited about European pension reform happening next year or the year after," says one analyst. "It will take two or three years for places like Italy to get the legislation through, and it may cost a few politicians' jobs along the way. In France, the people say: 'You touch my pension and I'll vote you out of power.'"
Measure for measure
For the time being, however, demand continues to outstrip supply. This is a problem not only for investors looking for inflation-linked paper offering relative value against nominal bonds, but also for investors simply looking for paper exactly matched against their liabilities. Although the market in bonds linked to euro zone inflation has taken off, the liabilities of most pension funds are more closely linked to their domestic inflation measures.
Infrastrutture, the Italian infrastructure finance agency, included a Eu750m 15 year tranche linked to Italian CPI ex-tobacco as part of a Eu5bn deal via MCC Capitalia, Morgan Stanley and UBS in January to help finance Italy's new high speed railway. And French funds have been well supplied by paper linked to French inflation by the French government and its agencies. But supply linked to other domestic inflation measures has been lacking.
For the time being, pension funds looking to match their liabilities with inflation-linked exposure have two options open to them, says Skobtsov. Either take out a derivatives contract linked to domestic inflation with a bank - which is likely to be expensive - or find the best match to what inflation-linked bonds are available.
"When we are approached by, for example, a Dutch pension fund, we will run a correlation study and make certain forward looking projections," he says. "We can then say that their particular inflation exposure is best matched by, say, 90% euro land inflation and 10% US inflation to take into account spill-overs from the US economy into euro land."
Just how long such calculations will be necessary is unclear. Some investors expect that once the euro zone inflation-linked market has deepened, both sovereigns and other borrowers might issue more transactions linked to their domestic measures. At the same time, the continued convergence between euro zone economies should mean that differences between national inflation measures narrow and euro zone inflation-linked bonds become suitable for a growing number of funds.