France is preparing its first issue of index linked government bonds for launch later this year. Since the US Treasury started issuing inflation linked debt, the product has gained popularity with investors worldwide. Will other European governments follow suit?
Will inflation linked bonds be the next fashion among the 11
European governments taking part in Emu? It will probably depend on
the success of France's inaugural issue, which is planned for later
this year or the beginning of next.
Apart from the UK, no other EU government has regularly issued index linked debt but interest in the product has increased since the US government's decision a couple of years ago to start issuing TIPS.
And there is already certainly considerable enthusiasm among European governments to follow the US's lead. With inflation rates in Europe at historically low levels but real interest rates still relatively high, they view this as an easy way to cut their borrowing costs.
That is because investors, in theory at least, would be willing to accept lower real yields if they knew they were protected against an uptick in inflation. And with private pension funds set to be established soon in several European markets, there is a strong potential investor base.
For the French government, inflation linked debt offers it a way of standing out from other European borrowers at a time when most governments are taking very similar steps to modernise their debt markets.
Some bankers believe there is investor demand for index linked debt - even though inflation is low. "The economy is in the middle of a recovery and you know what that means in terms of inflation," notes Denis Prouteau, head of government bond trading at Banque Nationale de Paris.
"There is also interest from investors because of the long term nature of these bonds: everybody seems to have a very good view on what inflation will be in two years.
"But if you ask them to put a figure on what the inflation rate will be in five, 10 or 15 years' time they will find it a great deal more difficult."
Bankers expect to sell the inaugural French issue to a range of institutions, including funds that have so far invested in alternative inflation hedges - such as real estate or equity. Prouteau foresees interest from retail investors as well.
However, not all French bankers believe the product will work. "I would be much more interested if they issued a bond linked to the unemployment rate instead," jokes one capital markets official, "but not this. I do not see what value it adds."
Index linked debt, he reckons, is a retrograde step at a time when inflation has been all but eliminated in Europe. "If institutions are looking for preservation of the real value of their capital, they will move into the equity market, not buy this," he argues.
The French government has not yet disclosed at what maturities it plans to issue index linked debt or the precise structure of its issues, but they are expected to resemble UK index linked issues with coupons made up of a fixed spread plus the latest CPI index - with the principal redemption indexed to CPI.
"They should issue at longer maturities - five years and beyond - to attract the real estate and equity style investors," says one French banker who believes that the product will be a success.