The attraction of linker bonds goes way beyond the protection they offer investors against rising prices. Sovereign issuers see them not only as a useful tool to extend duration — something they will doing a lot of next year following vast amounts of short term debt this year — but also as another deep pool of cash to soak up as their borrowing requirements surge ever upwards. Neil Day reports.
A critical question, as the global economy climbs out of the depths of the crisis, has been the extent to which government stimulus measures might have stoked inflationary pressures. The answer from breakevens in the inflation-linked market is that the situation is under control.
"We are pricing in just below 2% in 10 years for the eurozone and just above 2% in the US, and UK RPI of 2.9%, which is consistent with the CPI target," says one market participant. "All in all they are relatively fairly priced versus where the central banks want inflation to be."
Judging from past experience, this might be considered bad news for the development of the inflation-linked market. One banker points out that the emergence of deflation rather than inflation as the bugbear for the global economy as the crisis struck ended a promising period for the linker asset class during which, for example, Germany in 2006 launched the first Bund linker.
"Unfortunately, just as we were starting to get traction, we moved into this deflationary environment," he says.
But specialists are forecasting that, as governments seek ways to finance their heavy deficits, inflation-linked securities will enjoy renewed momentum.
"The asset class is going to be catching up with developments elsewhere," says Alan James, head of inflation-linked bond strategy at Barclays Capital. "All governments want to raise much more cash and inflation is a natural source of diversification."
He points out that the linker product can also provide governments with a welcome extension of their liabilities. "If you look at the UK," says James, "the duration sold on their two linkers this year was more than that achieved anywhere else."
The UK has been a step ahead of the game because even though index-linked Gilt supply is so developed, demand is even more entrenched.
"There is a huge pool of structural demand for inflation-linked assets in the UK," says Myles Clarke, joint global head of Royal Bank of Scotland’s frequent borrower group. "Indeed there is a mismatch in the need for linker assets and their supply and as it is very difficult for investors to meet their needs they use swaps and other means."
He says that the execution of inflation-linked Gilts this year illustrates the undersupply in sterling.
"In the UK there have been four syndicated Gilts this year, two nominals and two linkers," he says. "The execution of the linkers, although smaller, has been arguably better because demand is not as dependent on relative value on the day of launch.
"With the conventional Gilts, accounts can look at the relative value arguments for the deal and decide whether to buy
or wait to get some on the secondary market. But with linkers, they are reluctant to pass on the syndication given the limitations on liquidity on the secondary market."
Beating expectations
The most recent of the two linkers was a 40 year in late September. Leads Deutsche Bank, HSBC, Goldman Sachs and UBS built a book of £9.2bn, allowing pricing at the tight end of guidance of 1bp-4bp through the UKTi 2047 and letting the Debt Management Office size the deal at £5bn, above its £3bn-£4bn expectations.
"It became clear to us that the nature of the order book and its focus on our core domestic UK investor base — and well over 90% of this has gone to that investor base — meant that it is a classic opportunity for the pension fund industry and the insurance sector as well to transact in very large size, which they are unable to do in a normal auction," says Robert Stheeman, chief executive of the DMO. "We felt that, if they were really keen on that opportunity, we would be happy to extract a liquidity premium."
Investors also piled into a November 2042 linker launched in July, with orders of £8bn allowing a £5bn size and pricing at the tight end of guidance of 4p-7bp through the November 2037 UKTi. Barclays Capital, HSBC, JPMorgan and RBS were joint bookrunners.
Barclays expects index-linked issuance in sterling to be £40bn ($66bn) in the next fiscal year, which starts on April 1, and £35bn in the 2010 calendar year. The magnitude of the UK’s issuance is borne out by a comparison with the US, where Barclays expects $80bn of Treasury Inflation Protected Securities (Tips) in 2010.
However, in the US, too, inflation-linked issuance is on the increase.
"Amidst all the other upheaval in funding practices, the Treasury is highly likely to substantially increase Tips issuance in 2010," says Drew Matus, US economist at BofA Merrill Lynch Global Research in New York in a report on the supply outlook for the coming year. "[By doing so it will take] advantage of an increase in demand for Tips from both domestic money managers and overseas investors, including foreign central banks who view the class as a hedge against the risks of a continued weakening dollar and inflation."
Euros catching up
In euros, the market is even less developed than in the US, and there has been only one syndicated linker issue this year.
"There are some natural buyers — such as Dutch pension funds with a regulatory background that means they need inflation for ALM purposes, and a couple of French funds — but as a proportion of the total euro market it is tiny," says one banker. "So part of the reason there has been so little inflation-linked issuance in euros is just that the demand base is not so developed."
Not until late October did the first syndicated inflation-linked euro benchmark hit the market, when the Republic of Italy sold the first syndicated 30 year linker for a eurozone sovereign since March 2007. Leads Banca IMI, Barclays, BNP Paribas, Deutsche and RBS priced the Eu3.5bn deal at 13bp over the September 2035 BTPei.
While Italy was not relying on a domestic investor base in the way that the UK does, the distribution of the inflation-linked paper did provide the republic with diversification. Italian investors had a share of 11% — well below the 40%-50% share they took of the sovereign’s two syndicated nominal deals this year.
"I realised there is increasing interest in European inflation because I have recently travelled a little and saw, for example, Asian investors who were interested in diversifying their portfolios and they were looking to European inflation, which in the past was not so common," says Maria Cannata, director general of public debt at the Italian treasury.
Within the 89% sold internationally, 4% was sold to Asia, and North American accounts also participated — although some 44% of Italy’s deal was sold to the UK, underlining the country’s pre-eminence in European inflation-linked markets.
Philippe Laroche, public sector origination at HSBC, says that other sovereigns could take advantage of the investor diversification that he says is a major benefit of inflation-linked issuance.
"Demand across the world is extremely wide and could help countries to match higher than expected funding needs in 2010 and onward," he says.
Within the eurozone, Spain is being touted as a likely entrant into the inflation-linked market in 2010. During the country’s economic boom, when government debt was shrinking, the Tesoro focused its firepower on maintaining a liquid nominal market, eschewing inflation-linked issuance alongside foreign currency funding.
However, a deterioration in the country’s finances has given the Spanish treasury the leeway to issue a broader range of products, with the sovereign already having issued a dollar benchmark this year. RBS analysts, for example, expect Spanish gross bond issuance to hit Eu113bn by the end of 2009 — more than double 2008’s Eu57bn — and are forecasting Eu101bn in 2010.
"Spain intends to issue more in net bills and we expect greater issuance in US dollar paper and probably also linkers, for the first time," they said.
With Germany expected to launch a new 30 year linker, France forecast to issue two new lines in the 10 and 15 year maturities, and Italy due to return with a new syndicated inflation-linked bond, the eurozone is set to make up some ground against the UK market. Barclays estimates that there will be Eu60bn of inflation-linked issuance in euros in 2010.
Global potential
Analysts also believe that there could be European growth outside the eurozone. Sweden already has a well established market accounting for around 30% of its national debt (with a target of 25% in the long term) and Denmark is considered ripe for a move into the product.
"Historically there used to be a large inflation-linked mortgage bond market in Denmark, but that ceased a few years ago because of tax changes," says one analyst. "So investors in Denmark are used to inflation-linked securities and although we are not expecting Danish government issuance, it would be a logical move."
The potential for a rise in inflation-linked issuance is by no means a purely European phenomenon. On the other side of the world, the first index-linked Australian government bond since 2003 was launched at the end of September.
Deutsche, RBS and UBS built an order book of $5.5bn for the 3% September 2025 issue, allowing the Australian Office of Financial Management (AOFM) to size the deal at A$4bn and price it at 1bp over the August 2020 TIB (Treasury Indexed Bond), with about a quarter of the new issue being sold on an exchange basis to investors swapping out of a 2010 TIB.
"The deal was a lot bigger than initially expected," says one banker involved in the deal,"
Ahead of its comeback deal, the AOFM is understood to have visited the UK to discuss the workings of the index-linked Gilt market with both sides of the market, and also to gauge potential interest in its deal. The UK ended up taking about 20% of the Aussie linker, while another 11% was sold elsewhere in Europe and a little in Asia, although Australia took the bulk of the bonds.
"In the past, I don’t think they would have been able to place so much outside Australia," says one market participant."
Since the comeback deal, the AOFM has been launching monthly tenders of inflation-linked bonds and it intends to return with a fully-marketed bond in 2010. "We’ll consider issuing a new inflation-linked bond next year, most likely in the second half of the year," says Neil Hyden, chief executive of the AOFM.
And the government will, in the meantime, continue to raise money in inflation-linked format through regular auctions. "We expect to do tenders for inflation-linked bonds at about one a month," says Hyden.
Small in Japan — but maybe not for long
Asia is considered fertile ground by inflation-linked specialists, in spite of the product having failed its biggest test in the region.
In June 2008 Japan stopped issuing inflation-linked bonds and bankers hold up the Japanese experience as an example of how not to build a linker market.
The country began issuing inflation-linked bonds in 2004 and by the time issuance ceased in 2008 there was some ¥12tr ($134bn) of linkers outstanding. However, market participants say that there were fundamental flaws in the dynamics of the Japanese market.
"They had a massive issuance programme, but without any domestic support," says Jezri Mohideen, global head of inflation trading at RBS. "It was all supported by offshore buying, mainly hedge funds, who were buying on a value basis and not because of any real need."
This left Japan’s market vulnerable to the collapse in demand from leveraged accounts across the financial markets last year.
"They went from three monthly auctions to monthly auctions of ¥100bn or so," says one market participant, "but it was only when the market was failing that the Ministry of Finance went around trying to garner domestic support."
However, Mohideen says that there is no structural demand from Japanese investors.
"There is no inflation-linked element in pension provisions," he says, "and none in rentals because of their deflationary past. On top of this, a lot of ALM accounts could not buy because the Japanese linkers were not floored, so if there was deflation you could get into a situation where you lose your principal."
Once it has learned its lessons, bankers believe that Japan stands a good chance of building a better market.
"More than anywhere else, that market was based on leveraged money," says James at Barclays, "and if they are going to re-establish the market they will have to tap into domestic demand. I’m sure they will be able to do that — it’s just a question of how long it takes."
A successful restart in Japan would remove one of the obstacles to a growth in Asian inflation-linked issuance. "Some other countries were getting quite keen on issuing, but seeing Japan fail they backed off," says one banker.
The Ministry of Finance is said to be interested in restarting issuance and to be investigating how best to do so, including adding a floor to its inflation-linked product. That will be particularly important given that country has still not put deflation behind it — in November the government announced that, for the first time since 2006, Japan had re-entered a deflationary environment. Year-on-year inflation had turned negative in February, but it was not until the reporting of a 2.2% fall in prices in the 12 months to September that the government dubbed the economic situation a "mild deflationary phase".
Meanwhile Laroche at HSBC believes that the market will become more standardised, as the idiosyncrasies of countries like Japan get ironed out.
"The inflation-linked bond market has been fragmented by diversity of CPI and format," he says. "We believe that the market is adopting — more and more — the format of the US Tips and European linkers.
"That will be the major evolution in market practice in coming years."
Turkey trailblazer
A less developed country that is nevertheless held up as a positive example of how countries should build inflation-linked markets is Turkey. Whereas Japan ceased issuance in 2008, Turkey, despite some market disruptions, was able to issue more than expected, and could do so even though the country put its regular government bond issuance on hold.
"Due to the reduction in risk appetite caused by the global credit crisis, foreign investors’ demand to the domestic borrowing securities decreased," said the Turkish treasury undersecretariat in its 2009 public debt management report. "Consequently, after the second quarter of 2008, there hasn’t been a fixed coupon security issuance.
"On the other hand, the inflation-indexed bonds which were issued in February 2007 for the first time and contributed to the targets of increasing the borrowing maturity and widening the investor base, have been issued in every three months as announced in the 2008 financial programme, except for in November when the crisis deepened. Under these conditions, issuances of the floating rate notes exceeded the amounts that were projected at the beginning of the year."
Inflation-indexed issuance made up 2.3% of Turkey’s domestic borrowing in 2008. According to the Treasury Undersecretariat’s report, the country issued Tl 14.64bn ($9.8bn) nominal of index-linked bonds from the market’s creation in February 2007 to April 2009, with two lines outstanding: February 2023s and August 2013s.
"It is anticipated that inflation-indexed government bonds will continue to be reissued to generate the real yield curve in the upcoming period," said the Treasury Undersecretariat.
Turkey’s inflation-linked bonds are guaranteed against deflation (although generated an annual real rate of return of 10% and 12% for the 2012 and 2013, respectively, in 2008), but the main contrast, market participants say, between its success and Japan’s failure is the cultivation of the local investor base.
South Korea and Thailand are the two countries considered most likely to take up linkers’ cause in Asia, and elsewhere Israel is said to be a potential issuer. And market participants are bullish about the prospects for new entrants.
"There is no question that if any of these issuers come into the market right now even their local pension funds will have serious demand," says Mohideen at RBS. "Unlike Japan, some of these countries will have pension agreements where they have to be inflation-linked.
"Therefore we see it as a great opportunity for them to come and issue a relatively cheap form of funding."