Inflation-linked bonds Ready for take-off, or a load of hot air?

index-linked market


Even by the standards of financial markets, the inflation-linked market has been inordinately hyped during its relatively brief life. Bankers constantly reiterate the vast potential for issuance and investment. Every new issue is heralded as a breakthrough and every new mandate for investment is seen as proof that inflation-linked products are growing inexorably.

Yet – and though Credit is loath to admit when investment bankers' claims prove to be substantiated – it appears that there is some truth in the notion that inflation-linked bonds are coming of age. To be sure, the market is tiny compared with conventional bonds or credit. But new issuers such as Veolia Environnement, the first to issue a euro-denominated inflation-linked corporate bond, are finding willing buyers for their deals, and inflation-linked mandates are increasing as pension reform sweeps across continental Europe.

The inflation-linked market globally is estimated at $980 billion, most of which is accounted for by government bonds. The US accounts for 42% of the inflation-linked market, the UK 26% and the rest of Europe 22%, although Europe is expected to overtake the UK later this year. The UK is the oldest market, with the first issue in 1981; the market's global reach took another 15 years to achieve with issues in the US in 1997 and France in 1998.

As government deficits across Europe have increased, governments have turned to inflation-linked bonds to plug the gap. In 2003 Greece and Italy sold bonds and the market is currently buzzing with speculation about when Germany will issue. The rationale for issuance is straightforward: with little supply the inflation-linked market offers issuers great value as well as an opportunity to diversify their investor base.

Fresh demand

While supply has increased, appetite for inflation-linked assets has grown even faster as pension and insurance funds have been forced by regulators to match their liabilities. The European Debt Market Association (AMTE) notes that, assuming an asset allocation of 5% to inflation-linked, demand from French, Italian, German and Benelux investors alone would be €360 billion, as against the current outstanding of just €121 billion from these countries.

Much of the new money in inflation-linked bonds has been channelled through dedicated funds. An investor survey by ABN Amro at the end of May, shows that dedicated funds have grown their share of the inflation-linked market from 7% in 2003 to 30% in 2004.

Meanwhile, regular bond investors have increasingly bought inflation-linked bonds for reasons of diversification. BNP Paribas's quarterly fixed-income survey at the end of June found that while 25% of investors in such products were dedicated inflation-linked funds, 30% were other asset managers buying inflation-linked for diversification reasons. It noted that for such investors, inflation products represent on average 5% of their total portfolio.

Aside from diversification, inflation-linked bonds can be a source of alpha, or above-market returns, according to Helen Roberts, head of government bonds at F&C Asset Management, which manages £3.8 billion in inflation-linked bonds. "As you are guaranteed inflation, returns should be lower than conventional bonds but inflation-linked bonds have performed well over the last few years," she says. Inflation-linked bonds benefit when risk appetite is low, such as during geopolitical shocks.

Buy and hold

The evidence so far would indicate that investors primarily regard inflation-linked credit as a buy-and-hold asset. Certainly the experience of Veolia Environnement, which completed a €600 million 10-year deal at the beginning of June, indicates this is currently the case. Despite bookrunners ABN Amro, Deutsche Bank, HSBC and Ixis making a market in the issue, secondary trading has been non-existent.

Andrew Porter, head of European syndicate at HSBC, says that the deal was dominated by buy-and-hold investors whose reasons for buying were either to match liabilities, in the case of insurance companies and inflation-linked asset managers, or to own an instrument with different total return characteristics to the rest of their portfolio in order to increase diversification.

Despite the fact that Veolia had an established credit curve and was well known, which made it easier for a wide range of investors to judge the value of the new issue, a substantial amount of investor education was required, according to Alex Lalot, in origination for French corporates at Deutsche Bank. His colleague François Bleines, head of corporate new issuance, notes that many investors were uncertain about where the Veolia bond would sit in terms of client interest.

Nevertheless Philippe Bradshaw, head of corporate syndicate at ABN Amro, says that 50 accounts bought the deal, compared with up to 40 accounts in a similar UK inflation-linked corporate deal. "It will start to make sense to establish [investor] teams who understand the asset class," says Bleines. "That is most likely to happen if we can offer longer-dated issues, which is where much of the natural demand is."

Bankers are understandably upbeat about the prospects for further euro-denominated issuance but say finding the right issuers will be crucial. "The market is not ready for high-yield issuance but we could see activity from a wide range of single-A and double-A names," says Bradshaw. Although it was not economical to wrap Veolia to triple-A using a monoline insurer, it could make sense to wrap future issues, he adds.

The development of a wrapped market in Europe could see it begin to resemble the UK inflation-linked credit market – a mixed blessing. The UK has around €13 billion in non-government issuance outstanding, most of which is rated triple-A and often wrapped by monolines. "Issuers are concentrated in the utility sector, supranationals and are often wrapped," says David Dyer, investment manager, inflation-linked at Axa. "There are two Tesco issues and one BT issue – we need some new names."

But the UK experience – and indeed that of the US – indicates the difficulties of sourcing a broad range of issuers. The reason for the limited range of inflation-linked credit is straightforward, as Mike Amey, head of UK fixed income at Pimco, notes: there is not a huge array of companies willing to pay a coupon linked to inflation. Although issuers such as Tesco might access the market opportunistically, the mainstay of the market will always be companies with inflation-linked revenues such as utilities.

In addition, the homogenous nature of the UK market is to some extent a result of investor preference. Most inflation-linked investors value inflation protection more than yield gained through taking credit risk. "Investors want high-quality names, hence the wrapping of many deals, and prefer to take their credit risk in the more liquid nominal credit market," says F&C's Roberts.

Laurence Mutkin, head of fixed-income strategy at Threadneedle Asset Management, notes that BT is the only triple-B inflation-linked issuer in the UK and its deal was not issued at that rating. "I think any new deals at that level would struggle and there's certainly no demand for high-yield issues," he says. So is the UK corporate market – constrained as it is by the potential universe of issuers and the cautiousness of investors – as large as it will ever be?

Certainly, corporate issuance has largely dried up of late, largely due to investors being overexposed to utility paper and the market consequently being uneconomical for issuers. But Mutkin believes that there may be scope for new issues rated below triple-A while Porter at HSBC thinks investors would potentially buy triple-B paper. But, more importantly, both agree that issuance from outside the utility sector is desperately needed.

Companies involved in Private Finance Initiative (PFI) projects – a way of funding public investment through the private sector – could start to issue in greater volumes. That could result in a wider variety of credits, sectors and ratings on offer and could potentially change investors' approach to credit risk in inflation-linked bonds. But even inflation-linked credit enthusiasts acknowledge a mountain must be climbed for that to happen.

"There is scepticism about whether the corporate index-linked market will ever take off on any scale," says one investor. "Despite growing demand for such assets, the breadth of issuers necessary to create a deep market is not there. That has been the case in the UK and ultimately it may be the case in Europe." Fortunately for both investors and bankers there is an alternative to corporate issuance which is growing apace: inflation swaps.

Swaps allow companies with revenues linked to inflation to exchange part of their revenues for either a fixed return or more usually a payment linked to Libor. Crucially, swaps are independent of any funding requirements companies might have. While the cash bond and inflation swap market are closely correlated, the growth of swaps is not dependent on growth of the cash bond market.

Swaps are long-dated, often over 15 years due to the nature of utility companies' revenues, which makes them perfect for matching investors' liabilities. As a wider range of entities are willing to pay inflation in the swap market – hedge funds and bank proprietary desks are involved in the market in addition to corporates – the problems of diversification are also reduced.

HSBC recently underwrote a bond deal for Anglian Water that specifically tackled the issue of investor overexposure to the utility sector and tellingly provided supply for the inflation swaps market. Anglian issued inflation-linked bonds to an entity called Freshwater, which then sold conventional fixed-rate bonds. HSBC then used the inflation stream for inflation swaps. Crucially, investors' exposure was to HSBC rather than the utility.


For investors, inflation swaps are an efficient way to gain exposure to the inflation-linked market for several reasons. For a start the availability of more instruments gives the swaps market greater flexibility than the inflation-linked bond market, although prices for swaps tend to be attractive in the duration area, which has a corresponding index-linked government bond market, but become more expensive past the longest maturity of that range. Swaps can also offer optionality not available in cash bonds. For example, says Stuart Jarvis, senior strategist in liability-driven investment at Barclays Global Investors (BGI), investors can choose exposure to inflation up to a set cap, reducing the cost of the product.

Ultimately, as the swap market is over-the-counter, investors can request any product they like provided they are willing to pay for it. Swaps also require less capital to be tied up allowing investments in other assets, notes Tim Webb, head of fixed-income advanced active strategies at Barclays Global Investors.

Inflation swaps allow investors to be more creative in their portfolio management strategies. They can allow investors to create an inflation-linked bond for any name they like, says Luca Jellinek, head of rates strategy at ABN Amro. "You can just [hold a nominal bond and] pay part of its cashflows and receive inflation in return," he says. "Some of the larger funds have used this strategy in order to increase diversification."

This strategy of using inflation swaps and corporate bonds in combination to provide investors with their benchmark performance, or beta, and allow them to take credit risk through bonds to generate alpha does have some shortcomings. The main one is the limited – although growing – liquidity of the inflation swap market, which can increase costs for investors.

Using CDS

One alternative strategy is to hold inflation-linked bonds and take credit risk through credit default swaps (CDS) – either single name or iTraxx tranches – which have better liquidity than inflation swaps. Amey at Pimco says that while liquidity in inflation-linked bonds is not ideal, the combination of inflation-linked bonds and CDS has greater overall portfolio liquidity than holding corporate bonds and inflation swaps together. "The cost of unwinding the inflation swap structure if you want to restructure your portfolio is much higher than the other way around," he says.

The price you pay for such a strategy is that CDS has a shorter maturity – five or 10 years – than some corporate bonds. As most investors seeking exposure to inflation-linked assets want long exposure, holding inflation-linked bonds and selling protection on CDS creates a problem of credit reinvestment risk. "You need to hope that the credit market will give you the same yield it does today when the CDS matures," says Amey.

It should be noted that Pimco's attitude to using derivatives is considerably more progressive than most investors Credit spoke to for this article. Indeed, many investors are not happy using derivatives at all. "At present many pension schemes are happier to hold bonds and shy away from using derivatives," notes Peter Day, portfolio manager, fixed-income advanced active strategies at BGI.

Longstanding mandates may not permit the use of inflation-linked products or credit derivatives but Amey says that the pension fund market is changing and new mandates are usually more flexible. "Pension funds are now more comfortable with interest rate swaps because of the need to focus on liability-driven investment and as a by-product they have started to become more comfortable with other derivatives also," he says.

Inflation swaps are a far more likely recipient of any new-found openness towards derivative use than CDS. Even among investors not currently using inflation swaps there is a recognition that they are a tool that could be helpful for diversification or to outperform indices which are limited in terms of individual constituents: there are only seven stocks in the UK over five-year index-linked gilts, for example.

Furthermore, ABN Amro's investor survey notes that dedicated inflation-linked funds – the fastest-growing part of the market – tend to be most confident in using inflation swaps, suggesting acceptance of such strategies could increase rapidly. The same survey shows that inflation swaps have grown from 5% of the inflation-linked market in 2003 to 21% in 2004, even as the cash bond market has grown rapidly.

For many market observers inflation swaps are the future of the inflation-linked market: they can be tailored to investor needs and do not depend on issuers needing to borrow money. Indeed, despite the inflation-linked market's history of not living up to expectations, inflation swaps might be an area worth keeping a close eye on.

How inflation-linked bonds are managed

For asset managers with less than €35 million in assets, a pooled fund is likely to be more suitable than a dedicated fund. “They offer greater liquidity so clients can asset-allocate between pools over time,” says Tim Webb, head of fixed-income advanced active strategies at Barclays Global Investors (BGI). Pools are set up by maturities, with BGI having 22 funds, for example.

Most investors who use inflation-linked bonds to match liabilities benchmark a specific inflation rate such as the European Union ex-tobacco Harmonised Index on Consumer Prices (EICP) or the French or UK consumer price index. The benchmark might also be a government bond or an index that includes a number of government and other bonds, such as those compiled by Barclays Capital, Merrill Lynch, Lehman Brothers or the Euro MTS inflation-linked index.

Although many funds are called “dedicated” funds, they are not necessarily prohibited from owning other assets, such as conventional credit. “Increasingly clients want to add excess return and are therefore willing to allow non-inflation-linked asset allocations in inflation-linked portfolios,” explains Laurence Mutkin, head of fixed-income strategy at Threadneedle Asset Management. Indeed most investors agree that inflation-linked bonds are best managed alongside conventional government bonds, as the breakeven trade – one of the key trades in the market – relies on taking advantage of the difference between the yield on straight bonds and inflation-linked bonds of the same maturity.

Helen Roberts, head of government bonds at F&C Asset Management, says: “Breakeven trades can add substantial value to the overall portfolio,” especially if an investor is able to over- or underweight inflation-linked bonds depending on their view on inflation or breakeven levels. Similarly, some investors prefer to consider inflation-linked products along with a wider range of assets, including credit, when investing for a dedicated portfolio. “We always seek to compare all asset classes and seek out the most attractive at any time subject to the risk the client is willing to take,” says Mike Amey, head of UK fixed income at Pimco. Amey adds: “For pure index-linked portfolios we would seek to invest elsewhere if it offered a better return though there would always be some inflation-linked in the portfolio.”

For all investors, liquidity is a challenge: sovereign issues tend to be reasonably liquid – though not compared with the non-inflation linked market – but many smaller issues may be tough to trade. “We strongly believe in actively trading inflation-linked bonds and take duration, yield curve, asset allocation and stock selection positions,” says Roberts at F&C, who concedes that the market is not as liquid as she would like.

The reasons for limited liquidity are fourfold: deal sizes tend to be smaller than the conventional market; bonds tend to be longer dated; often outstanding bonds are stripped of their inflation components for use in the swap market; and the behaviour of many investors contributes to illiquidity. As Stuart Jarvis, senior strategist in liability-driven investment at BGI, notes, index-linked credit is often held to maturity to match liabilities.

Mutkin at Threadneedle says that the liquidity that active managers consider vital is not important to everyone. “Some funds simply want to buy something and lock it away and corporate issues can fulfil that role. The driving force in inflation-linked is not ’let’s make 300bp of alpha from a quirky and moderately illiquid market’. Rather it is to get close to your liabilities.”

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