It’s 20 years since the UK government started issuing index linked bonds, and unlike the fixed rate bond market, the sector has until recently been largely bereft of corporate issuance. That’s changing, as low yields and strong demand from key investors encourages mainstream UK companies to borrow money in index linked form.
Here we look at the what this new market means for investors. What are the opportunities, and what are the risks?
What are corporate index linked bonds? Fixed rate corporate bonds provide investors with higher yields in exchange for credit risk – the risk that the issuing company does not fully repay both the interest and capital that they owe. Index linked corporate bonds follow the same basic methodology. They provide a higher real return over and above inflation, for a reduction in the certainty of that return.

Three types of borrowers are active in the UK corporate index linked market:
o Companies whose income is primarily inflation linked (regulated utilities such as National Grid and British Telecom are good examples) have an incentive to build an inflation linked cost of capital into their balance sheets – it reduces their financial risk. There will also be periods when lower real borrowing costs can be achieved using index linked debt as an alternative to fixed rate issuance.
o Special purpose issuers have used the index linked market as a means of securitising mainly inflation linked revenue streams. Examples include toll road projects and rental income from partially privatised government buildings.
o Supranational entities such as the European Investment Bank have issued index linked bonds as a result of specific demand from, predominantly, UK pension funds. Such buyers often have a need for ‘AAA’ rated securities that provide a higher real yield than government stocks.
The result has been a new market valued at around £5bn (e8bn), containing just under 40 issues with ratings spread across the investment grade spectrum. New, because some 90% of this issuance has occurred in the last 18 months. The market is developing rapidly, and will continue to do so as investor and borrower sophistication rises.
For investors, an exposure to corporate assets increases both risk and return, providing a wider playing field for active managers in particular. How should they exploit this opportunity? Credit analysis is an essential element of investment in corporate debt. However, investors must assess not only the risk of default but the pricing that the markets have applied to each issue.
There is nothing wrong with owning a bond whose credit rating is expected to decline if the impact of downgrades has already been reflected in higher yields. Conversely, there is little point in an active manager owning issues with stable ratings if the market has already afforded them premium pricing.
Examples of this are plentiful. The Tesco 4% 2016 index linked issue has a stable ‘Aa3’ rating. It is also a well known name that attracts interest from retail investors, and as a result it trades with a modest yield spread of 1% over government issues. Modest, because a number of more secure, ‘Aaa’ rated, securitised issues provide almost the same yield spread and therefore represent much better value.
Similarly, stocks that trade poorly often have the greatest degree of bad news priced into them and present the most attractive opportunities. The British Telecom 3.5% 2025 index linked bond provides a perfect case study. Earlier this year it yielded over 3% more than government index linked stocks, reflecting the poor sentiment impacting the telecoms sector at the time.
Yet this level of yield spread indicated that the market was pricing in a decline in credit rating to below investment grade, way below most investors forecasts of a ‘BBB’ rating. Since April, and despite being downgraded, the bonds have rallied by over 1% in yield terms, or around 15% in price terms relative to government stocks. In effect, they have moved from an excessively cheap level to reach a fair reflection of their eventual credit profile.
The message for investors is that opportunities exist, not just through trying to find the ‘safest’ credits, but by actively considering the combination of rating outlook and market pricing. One hurdle that remains is liquidity - many corporate index-linked bonds are purchased in the primary market as ‘buy and hold’ investments. Even now, however, price volatility of the magnitude discussed above leaves opportunities to add value net of trading costs
Another characteristic of all index linked bonds is their long duration relative to fixed rate bonds of the same maturity. This means that any increase in the credit spread of a corporate index-linked bond has a much greater impact on prices than the same spread widening on a fixed rate issue. This doesn’t make the bonds unattractive, but investors must be aware of it when comparing index linked and fixed rate credit spreads.
An ‘exotic’ offshoot of the corporate index-linked world, one that is generating particular interest among UK pension funds, is limited price indexation (LPI) bonds. LPI describes a modification of the way in which inflation is added to the returns of corporate index linked issues.
Essentially, the bonds provide a yield that is uplifted by inflation, but subject to a maximum of 5% per annum, and a corresponding minimum of 0% per annum. What this means is that in the event of very high or very low inflation (and even deflation) the bonds cease to be index-linked.
Who would want such a structure? A number of UK pension funds adopt an LPI regime that requires them to uplift pension benefits by inflation each year, subject to a 5% cap and a 0% floor. For these investors, LPI corporate bonds are close to ideal. They provide higher returns than government stocks through access to corporate credit risk, and provide an improved match for the inflation risk generated by pseudo-real pension liabilities
LPI tranches have been included in some of the most recent corporate bond deals – notably by Glas Cymru and National Grid. Issuance size is small, and these instruments are universally a ‘buy and hold’ investment for the time being. But as another element of the financial engineers toolkit they are a useful addition.
Investors confined solely to publicly issued corporate index linked bonds have, for now, a relatively small universe of stocks to choose from. However, the derivative markets provide access to all of the necessary building blocks to construct synthetic securities combining inflation linked cashflows with credit risk premia.
It is relatively simple to add a diversified yield premium ‘layer’ to an existing government index-linked portfolio using interest rate and credit default swaps.
The premium element would not be inflation linked, but this sacrifice is modest compared with the magnitude of the benefits - access to the full range of global corporate borrowers and the ability to actively trade credit exposure without impacting the underlying index-linked bond portfolio. As a way forward for the pro-active investor, unconstrained by the conventions of traditional pension fund investment, this looks highly attractive.
Corporate index linked bonds are an ‘emerging’ asset class in terms of diversification and liquidity, but will only increase in importance as the credit markets become the natural home for pension fund fixed income investment.
Active managers need to combine credit and market analysis in order to exploit corporate index-linked bonds in their portfolios. LPI is one offshoot of the inflation linked world that has a particular application for UK pension funds seeking to immunise liabilities.
As markets broaden, funds should start to consider the true building blocks of corporate credit risk, using the derivative markets as a means of building efficient portfolios that meet their true needs.
Andrew Wickham is fixed income fund manager at Schroder Investment Management (UK) in London