Forgotten, but not gone

A growing number of Australian infrastructure projects are looking to include a consumer price index element in their financing, giving a boost to the nascent Australian inflation swaps market. But is there sufficient demand for inflation protection from pension funds? By Wietske Blees

Australia has long been the forgotten inflation market. While country after country kick-starts its own government inflation-linked bond market, ups issuance volumes or introduces longer maturities, Australia has allowed its government index-linked bond market to slowly wind down. Just A$6.02 billion ($5.37 billion) of Australian Treasury indexed bonds were in issue as of June 2007, compared with A$47.2 billion of nominal bonds. Since a review of the Australian bond markets in 2003, in which the Australian Treasury mooted paying off all outstanding debt¹, not one index-linked bond has been issued.

At the same time, the market hasn't exactly been overwhelmed with demand for inflation assets. This is in stark contrast to other markets, such as the UK, the Netherlands and Denmark. In the UK, for instance, pension funds are obliged to calculate their pension liabilities using a discount rate based on AA-rated corporate bond yields and report them on their balance sheets. Under pressure from the UK Pensions Regulator to eliminate deficits, defined-benefit pension schemes have been piling into long-dated nominal and inflation-linked bonds and swaps.

In Australia, it's a different story. While defined-benefit liabilities must be backed by assets in a separate trust or fund and reported on company balance sheets, defined-benefit schemes make up only a small proportion of Australian superannuation funds - the vast majority are defined contribution.

What's more, a survey by consultants Watson Wyatt, published in August, suggests liabilities of defined-benefit schemes in Australia are broadly covered by assets. The survey of the top 170 companies listed on the Australian Securities Exchange reported liabilities at A$40 billion (this figure did not include public-sector defined-benefit liabilities or Australian subsidiaries of overseas companies). Once the value of assets had been taken into account, however, defined-benefit schemes had a net liability of less than A$1 billion. In comparison, pension liabilities for the 350 largest companies in the UK reached £9 billion as of September 30, 2007, according to consultancy firm Mercer. That's a significant improvement from the £30 billion deficit as of mid-August - largely due to volatility in equity and bond markets.

The relatively healthy state of Australian superannuation funds, combined with the illiquidity of the inflation market, means demand for inflation protection has been sketchy in the past. "Over the years, many defined-benefit pension funds have been proxying some of their inflation-related liabilities with other assets, such as equities, because there was a perception that the derivatives and physical markets were not large enough for them to trade in at a reasonable cost," says Stephen Nash, head of fixed income and cash at State Street Global Advisors Australia.

However, there are signs that Australia's inflation market is beginning to build up a head of steam. While the Treasury is sticking to its plans to run down its outstanding index-linked issuance (currently comprising three classes of notes with maturities of 2010, 2015 and 2020), a growing quantity of Australian infrastructure projects are turning to the inflation market to hedge consumer price index-linked revenue streams. A number of infrastructure consortiums have launched inflation-linked bonds, while others have hedged their exposure to inflation using swaps. Approximately A$6 billion of inflation-linked bonds issued by infrastructure projects and other corporates are currently outstanding, with around A$1.8 billion issued last year.

"Since early 2006, the void created by the government's lack of issuance is gradually being filled with infrastructure projects. The market has begun to show incredible signs of life," says Ralph Segreti, director, global inflation-linked product manager at Barclays Capital in London.

State governments in Australia are responsible for constructing infrastructure projects, which they outsource to consortiums typically comprising finance parties, construction firms and service providers. When finalised, the state government will enter into a long-term lease with the consortium, with payments rising by the rate of inflation each year. By issuing an inflation-linked bond, the consortium can therefore match its assets and liabilities over the term of the lease. These notes are often guaranteed by monoline insurance companies and hence achieve AAA ratings, opening up the bonds to a wide variety of investors that are required by internal ratings to invest in high-rated securities.

"The fact that these projects have long asset-lives and government-linked revenue streams lends itself to being credit wrapped by the financial insurance agencies, and they typically receive AAA ratings," says Peter Berckelman, director in the investment banking group at Barclays Capital in Sydney. "Unless you've got these good asset ratings, it is very difficult to sell such bonds to asset managers."

A flurry of infrastructure deals has come to the market over the past two years. For instance, in December 2006, Sydney airport issued A$300 million of 3.12% inflation-linked bonds due in 2030, lead-managed by Macquarie Bank. The AAA-rated bonds were guaranteed by New York-based monoline Ambac Assurance. In the same month, Reliance Rail financed the replacement of carriages and trains on the Sydney rail network with A$1.9 billion of bonds via ABN Amro. The transaction included $300 million index-linked bonds due in 2035 and more than A$1 billion of 30-year-plus inflation swaps. The inflation-linked bonds were rated AAA and were guaranteed by New York-based XL Capital Assurance and London-based FGIC UK.

But it's not just the infrastructure companies dipping their toes into this market - overseas issuers have also been involved. In September 2006, the European Investment Bank issued A$250 million 2.37% index-linked bonds due in August 2020, lead managed by Citi and National Australia Bank. Then, in February this year, Dutch banking group Rabobank issued a A$380 million 2.805% inflation-linked bond due in August 2020, with ABN Amro and Commonwealth Bank of Australia acting as bookrunners.

At the same time, interest in inflation-linked assets is also starting to pick up among asset managers and pension funds. That's partly a consequence of increased supply. With little issuance by corporate entities until relatively recently, and a virtually non-existent swaps market, anybody wanting to buy inflation-linked assets had to battle to source dwindling Treasury indexed bond supply - much of which was being held to maturity.

"In Australia, inflation products have been around for a comparatively long time, and as a result Australian investors and issuers are among the most knowledgeable I have come across in any market," says Dariush Mirfendereski, managing director and head of inflation-linked trading at UBS in London. "Their one big problem has been a lack of supply, as the government has not tapped the existing bonds or issued new bonds. But infrastructure companies and state governments are issuing, thus filling the gap."

Even though Australia's pension funds are not under the same regulatory imperative to match assets and liabilities as those in the UK, there is a growing awareness of the benefits of inflation as part of a diversified portfolio, say dealers. "The increased allocation to inflation is not driven directly by regulation, but by a global push to match inflation liabilities better. It can be seen as a de-risking of portfolios after many have done well by investing in equities and growth assets against consumer price index liabilities," says Andrew Barrelle, head of inflation Australia at ABN Amro in Sydney.

In fact, a growing number of defined-benefit schemes are looking to lock in surpluses by using inflation-linked bonds and swaps. "For pension funds, using inflation-linked bonds when running budgetary surpluses makes more sense than doing so when running deficits. In the case of the former, they are de-risking from a position of strength, whereas in the latter case, de-risking would mean locking in their losses," says Mirfendereski.

Investors have been encouraged by growing liquidity in the inflation market. As well as an increase in inflation-linked bond issuance, the swaps market has increased substantially over the past few years. In fact, activity in the swaps market has far exceeded that of bonds, and dealers reckon that will continue as investment managers become more familiar with the product and mandates are changed to allow trading of inflation derivatives.

"Between 2000 and 2004, we saw only sporadic trading in inflation swaps and bond issuance. In 2005, the market began picking up, but inflation swaps began to grow dramatically in 2006, with approximately A$9 billion of trading," says Barrelle. "For 2007, we expect these figures to be in the range of A$5 billion-7 billion. In the absence of official figures, we estimate total inflation swaps outstanding to be approximately A$16 billion, with the majority of these transacted in the past two years."

One of the biggest participants in Australia's inflation swaps market is fund manager Queensland Investment Corporation (QIC). In late 2006, QSuper, one of the largest superannuation funds in Australia, with A$50 billion under management, requested QIC to source inflation-linked bonds as part of its investment strategy. Given the shortage of supply, the firm opted to trade A$2 billion in inflation derivatives - then the largest inflation swap transaction conducted in Australia.

"Investment objectives and liabilities are often linked to inflation, so there is a lot of sense in considering assets linked to it. Also, inflation as an asset class is a great diversifier in its own right, so there are arguments to consider it solely on that basis as well," says Adriaan Ryder, head of beta management at QIC in Brisbane. QIC manages several of QSuper's funds (the defined-benefit, balanced growth and high-growth funds) by separating alpha and beta across the entire portfolio. Ryder says the asset mix within these funds is chosen to maximise the probability of meeting all the investment objectives.

State Street Global Advisors' Nash agrees inflation can be an attractive investment from a diversification standpoint: "Long-dated Australian zero-coupon inflation-linked swaps now offer over 3% real yields, which are attractive for funds with real targets of 5% or 6%. By using a zero-coupon swap at 3%, they only need to add another 3% or so through other sources, such as long/short equity or leveraged fixed-income strategies, and this should not be that difficult."

With more dealers, asset managers and pension funds entering the market, bid/offer spreads have tightened significantly over the past few years - another reason why Australian institutions are more open to using inflation swaps. "The basis-point bid/offer spread on a 10-year zero-coupon swap used to be 10bp. Now it's averaging about 5bp and on a good day it can be down at 3bp," says Nash.

But there are still substantial hurdles to overcome. For one thing, the longest outstanding Treasury indexed bond matures in 2020, meaning there is no benchmark for longer-dated inflation-linked bond issues. "Traditionally, a government bond goes out sufficiently far to define the state of the inflation curve, and swaps will fit around this curve. If you're talking about a 30-year transaction while the longest bond is only going for 13 years, it is difficult to find a benchmark," says Christian Alibert, co-head of inflation trading at Royal Bank of Scotland in London. "Particularly considering the volatility of the yield curve this year, you are not going to be satisfied using a 13-year bond as a reference point for tracking the moves in a 30-year swap."

Some dealers point to a A$268 million index-linked bond issued by Queensland Treasury Corporation in June 2006, which matures in 2030, as an alternative. "The 2030 Queensland bond is another point on the curve, and there are the 2010, 2015 and 2020 government bonds, as well as a nominal bond curve. Taking these together, you have a fairly good framework for establishing where prices should be," says Mirfendereski. "Furthermore, while a lot of these infrastructure projects are long-term dated, they still have amortising structures, meaning a good chunk of the risk still lies within 15 years."

Others, however, note that the swaps market is likely to evolve as the key pricing reference for inflation. "The 2030 Queensland bond is not large enough to be a meaningful, liquid benchmark, so the lack of government issuance is certainly an issue," says Barclays Capital's Berckelman. "But market participants will seek substitutes through swaps, and swaps themselves will probably become the benchmark in the same way swaps rates are the benchmark for some other markets where there is also no real government bond market."

But one thing in Australia's favour is that it is not currently hampered by the supply and demand mismatches that have blighted other markets. While pension funds in some countries have had to scratch around to source inflation supply, there appears to be plenty of infrastructure projects in the pipeline - including a sizeable transaction from the Royal Children's Hospital, a Melbourne public private partnership.

"Invariably in inflation markets, the trickiest point to find is natural supply. You only have to look at the US market, which has really struggled because of a lack of natural supply. Supply is something Australia has in abundance, so if it has a supply and demand mismatch, it has a very good one," says Alibert.

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