In response to rapidly growing demand for inflation-linked bonds, the International Index Company (IIC), provider of bond and credit derivative indices, has launched the first ever non-proprietary family of inflation-linked indices. The new structures, called the iBoxx Inflation-Linked Index Family, offer benchmark indices for the major global sovereign and quasi-sovereign inflation-linked bond markets, collated through multiple-dealer pricing.
The Frankfurt-based chief executive of the IIC, David Mark, says that the creation of the new iBoxx inflation-linked indices comes at a time when both supply and demand for inflation-linked debt is at unprecedented levels. "The inflation-linked bond market is growing steadily, both in traded volumes and importance for investors, and the new indices address their needs," he says.
The US sold its first issue of Treasury Inflation-Protected Securities (Tips) in 1997, more than 15 years after the UK kicked off the modern-day inflation-linked bond market by selling £1 billion of index-linked gilts. Other global government inflation-linked issuers include Australia (1985), Canada (1991), Sweden (1994), Italy (1998), France (1999), Greece (2003) and Japan (2004). Germany looks set to join the list of sovereign issuers of inflation-linked debt by year end, committing between EUR5 billion and EUR10 billion.
According to IIC the market for inflation-linked bonds has more than tripled in terms of real market value over the last five years, from $210 billion in 2000 to $661 billion at the end of December 2005.
Much of the demand for inflation-linked debt has been triggered by escalating commodity prices and rising interest rates in developing nations, both of which have forced investors to ponder their future purchasing power. At the same time, upcoming regulatory changes will force many European pension and insurance investors to gear their investment strategies towards matching liabilities and assets rather than maximising returns. These regulatory changes include the implementation of the new Basel Capital Accord in 2007, the European Commission's Solvency II insurance regulations, the Netherlands' new Financial Assessment Framework and changes in international accounting standards.
"There is appetite for inflation-linked debt among pension and insurance investors, which you can see by the premium of these bonds having gone up considerably," says Fergus Lynch, head of index development at Deutsche Bank in London, who was also involved in the structuring of the IIC's new indices. "There is a very distinct focus on this asset class among all types of money managers, right across the spectrum."
Investors use the inflation-linked market for a number of purposes. One is to hedge against an unexpected rise in inflation or long-term interest rates. As inflation-linked bonds react positively to inflation, these instruments provide diversification to a portfolio and improve the risk/reward profile for long-term investors. A number of asset managers are also opting to use inflation-linked bonds over nominal bonds to achieve similar returns. The distinct advantage of inflation-linked bonds is lower risk and lower correlation to other asset classes such as equities, thereby reducing volatility in the portfolio.
In addition, by using the global inflation-linked bond market, currencies can be hedged against one another to produce a higher expected return and a lower risk in a portfolio. Again, this is because they are more diversified and less correlated with domestic assets. Also because the global inflation-linked bond markets are much larger in size and liquidity, larger positions can be taken thus lowering transaction costs.
Bond prices on the index are provided by five investment banks: BNP Paribas, Deutsche Bank, HSBC, Morgan Stanley and UBS. The indices are calculated and published three times daily to correspond with the close of the US, European and Asian markets. Mark says the purpose of the index is to provide a neutral platform where customers can receive pricing from multiple sources.
One notable absence from the list of pricing contributors for the iBoxx inflation-linked indices is Barclays Capital. Barclays' global inflation-linked index has been a leading constituent of the market since its launch in 1997. Its capitalisation is currently near $800 billion and is expected to reach a trillion dollars during 2006. Among its inflation-linked index products, Barclays also offers US government and sterling inflation-linked bond indices, and a South African government inflation-linked bond index.
John Williams, head of index products at Barclays Capital in London, says that although his firm looked at joining the iBoxx inflation-linked index group and is active with other iBoxx products, "we decided it would serve our clients better if we concentrated on our own index. It's very widely used and highly regarded and it's a core part of our product offering for inflation," he says.
Late last year Barclays launched a real-time index and analytics platform that provides additional transparency to the markets. Liquidity is now such that investors can access the market with little fear of punitive dealing costs should they wish to exit. Lehman Brothers and Merrill Lynch also offer their own proprietary indices for inflation-linked bonds and are not pricing contributors of the new iBoxx platform.
Platforms such as the iBoxx inflation-linked index can add a significant amount of liquidity to the market, says Lynch at Deutsche Bank. But the bonds chosen for inclusion must also be liquid, he adds: "Essentially when you build a good index it must include markets that are significant to the end investors. You don't want to include bonds from a country that has issued a single inflation-linked bond and that does not attract much attention. You have to ensure that the markets you include are sufficient in size and that the bonds are sufficient in liquidity as well."
As a result, for bonds to qualify for the iBoxx inflation-linked indices, they must be investment-grade, government-issued and have a minimum issue size of $2 billion. This differs from the eligibility requirements for proprietary indices, such as the Barclays Capital Global Inflation-Linked Bond Index, which has a much smaller minimum deal size of $100 million face value.
Although some asset managers argue that the IIC's high minimum deal size risks being seen as exclusionary, Vincent Kok, head of international fixed income at State Street Global Advisors in London, says this is of little consequence in today's markets. For one, says Kok, "governments tend to issue in large amounts in order to create liquidity benchmark bonds. They are not interested in having small issues that will take up space on their book-keeping and reporting." And from an investor's point of view, Kok says: "It really moves us away from the small illiquid issues which frankly do nothing to diversify the portfolio."
State Street's Kok anticipates that the iBoxx platform will eventually become the new benchmark. "Having a panel of investment bankers pricing securities and picking roughly an average of them gives you at least some comfort that this is the best price we can possibly achieve," he says.
According to Mark at the IIC: "And that already makes it more attractive to the customer whether he is a pension fund or an asset manager, because it means that he is likely to find tighter spreads. He is not bound to buy and sell whatever that product might be with just one bank."
With more players such as mutual funds and hedge funds showing an active interest in the inflation-linked bond indices, not just as a benchmark but also as a source of information, Barclays' Williams says there could be a lot more in store for this market.
HOW THE IBOXX INDICES ARE STRUCTURED
The new iBoxx inflation-linked indices comprise six separate platforms:
1. Overall global index
2. Regional indices for North America, Asia and Europe
3. Currency indices for Canada, US, Europe, UK, Japan and Sweden
4. Country indices for Canada, France, Greece, Italy, Japan, Sweden, UK and USA
5. Three separate maturity band indices of between one and five years, five and 10 years and greater than 10 years
6. Base inflation indices. These use a public inflation measure to index the bonds. For instance the US consumer price index is the base inflation index for the US Tips market.
The iBoxx inflation-linked indices are fully rules-based. At launch, 55 bonds were included in the global index. This has now increased to 57 after two new issues in January. The index constituents will be rebalanced every month to provide opportunities for new eligible bonds to enter.