After outperforming last year, Jonathan Sibun asks is it time for the inflation note to emerge from its niche?
“There has been about Eu9bn of issuance year to date under EuroMTN programmes. That’s a phenomenal volume and people have been surprised by the take-up in the product.”
The “phenomenal” product that Chris Jones, Deutsche Bank’s head of EuroMTNs, was talking about just before Christmas is the inflation note, of which much was expected by bankers at the start of 2003. It didn’t disappoint.
Inflationary fears, falling interest rates and investors looking to protect their returns all drove strong demand and boosted inflation issuance last year.
However, while the inflation market did take off, the product has yet to establish itself at the core of the EuroMTN business.
Notes have been bought by a variety of investors: not just the institutions wanting to hedge natural inflation-linked liabilities, but also retail buyers. But, in comparison with other products, numbers remain restricted.
“If you look at some of the other structures — range accruals, target redemption notes, equity-linked — the reason they continue to be popular is because they have a much more diversified buyer base,” says Frair Appleby-Walker, a EuroMTN trader at BNP Paribas in London.
In contrast, the buyer base for inflation product is still very much contained within the Italian retail, the French institutional and, to some extent, the Swiss and Austrian markets.
However, the signs are healthy on the sellside — Italy and France will continue to be active in 2004 and Germany and Japan have both said they expect to issue an inflation-linked bond.
“If Germany does choose to issue then it probably won’t just be a one-off deal but rather a programme of deals over the next year or two,” says Deutsche’s Jones.
Deals such as those expected from Germany and Japan will vastly increase the volume of assets in the sector, thereby providing houses with the opportunity to hedge further swaps in new issuance.
But there are impediments to growth, among them the fact that the market has so quickly become commoditised, thereby reducing yields. That has prompted houses to look at hybrid notes or notes offering multiple exposures to inflation.
There are also other threats to growth. “There have been policy changes in the Italian market recently that may well impinge further on how well one is able to market to an Italian retail client,” says Appleby-Walker at BNP Paribas. “But where we may see a drop-off in retail we will continue to see demand on the institutional side.”
On the plus side the lack of yielding products could lead to further innovations. “I think we’ll see the creation of the inflation derivatives and the suite of exotic derivative products that are already traded for the Libor index,” says Nabil Abouzelof, head of EuroMTNs at Barclays Capital in London.
With issuance this year set to exceed 2003 volumes and the economic fundamentals looking increasingly positive for the product, 2004 should prove to be another strong year for the inflation-linked EuroMTN market.