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ESG: The metrics jigsaw


Don't let inflation run away with your money

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Inflation-linked bonds offer bond investors a real return - a return linked to inflation. For a diversified bond portfolio, inflation-linked bonds offer an attractive risk/return profile. As liability matching has become an increasingly high priority for pension funds and insurance companies in the wake of falling equities, ageing populations and regulatory requirements, demand for inflation-linked bonds has soared. The global market in inflation-linked securities has grown significantly in recent years as more governments have begun to issue inflation-linked bonds, meeting the growing demand. Looking ahead, inflation-linked bonds are set to become an increasingly desirable ingredient for bond investors. The global market in inflation-linked bonds is set to grow and evolve, particularly as inflation rates in different countries converge – a trend that has been in evidence for the past few years. As the market grows in liquidity and breadth, this will also add to the attraction of the asset class.

With increasing regularity, we are asked by investors about the role that inflation-linked bonds can play in a portfolio. We therefore outline the asset class in this viewpoint.
What is an Inflation-Linked Bond?
An inflation-linked bond is different from a conventional bond. Both pay a regular interest payment, or coupon, and also pay the holder the face or par value of the bond at the redemption date. However, for inflation linked bonds, the coupon and face value of the bond are automatically increased at regular intervals to compensate for inflation, by tracking an inflation index. For example, in the UK, inflation-linked or index-linked gilt coupons and face values increase in line with the UK Retail Price Index (RPI). In the US, Treasury Inflation Protected Securities (TIPS) track the US Consumer Price Index (CPI).
Inflation-linked bonds offer investors not only the low risk characteristics offered by other bonds, but also offer a real rate of return. Conventional bonds do not offer this, since returns are affected by inflation rates over the life cycle of the bond. In addition, inflation-linked bonds tend to be less volatile than conventional bonds, which can give them a more attractive risk/reward profile than conventional bonds.

A History Lesson
Back in 1780, the state of Massachusetts issued the very first inflation-linked bond. After the Second World War, countries including Israel, Argentina Brazil and Iceland issued inflation-linked bonds. However, the modern market began to blossom in 1981, when the UK government issued inflation-linked bonds for the first time. At the time, UK inflation was running at around 15%, and memories of inflation of over 25%, as seen in the mid 1970s, were fresh. For the British government, it was a way of re-attracting bond investors; government bonds had fallen out of favour in the high inflation environment and UK investors’ attention was firmly on equities. In 1981, the environment was ripe for a bond that offered a rate of return that would not be hurt by inflation, and for investors including pension funds, it was a necessity.
In 1983, Australia entered the market and in the early 1990s, Canada and Sweden also issued their first inflation-linked government bonds. However, the market has expanded rapidly in recent years and the global market is now worth around e380 bn. In the last three years alone, it is estimated that the global government inflation-linked bond market has doubled in size. US TIPS were launched in 1997, while the French government launched the OATi in 1998. In 2003, both the Italian and Greek governments entered the market. In early 2004, Japan issued its first inflation-linked bond and although only domestic Japanese investors can currently buy these bonds, it is only a matter of time before the Japanese market opens up to overseas investors. However, in the near term, international demand for inflation-linked Japanese government bonds is likely to be minimal, on deflation concerns. Germany may also be about to enter the market: it has recently investigated the rules and regulatory requirements both for issuing inflation-linked bonds and for pension funds to buy them.
The breakdown by country of the global inflation-linked government bond market at the end of 2003 is illustrated in the chart. Although corporates have begun to issue inflation-linked bonds, this type of bond only represents a small slice of the overall market at present.

Supply and Demand
It may seem strange that the market has grown so rapidly in recent years given that globally, inflation has been at very low levels compared to historic averages. However, even in a stable, low inflation environment, there is some uncertainty about the real value of nominal bond returns over the life of the bond. If inflation averages 1.0%, in 30 years time, £100 would have purchasing power of only £74. On the other hand, if inflation averaged 2.5%, the same £100 would have only £48 worth of purchasing power. No other asset can give the same certainty over future real value that an inflation-linked bond can offer.
In the past few years, demand for inflation-linked bonds has risen significantly in Europe and the US. In the wake of falling equities and increasing regulatory requirements aimed at ensuring that liabilities can be met, demand from pension funds and insurance companies has soared. In addition, as population demographics have shifted and increasingly a greater proportion of populations enter retirement (see Viewpoint: Demographics & Pension Funds, July 2002), this has also supported demand from pension funds for low risk investments that offer real rates of return. F&C has seen a notable increase in demand for global inflation-linked pension portfolios over the past year and this trend is likely to continue as pension funds mature and liability matching becomes increasingly important.
Other sources of demand for inflation-linked bonds include savings protection for retail clients; in parts of Continental Europe, and particularly in France, some savings products offer a real return, and make use of inflation-linked products to achieve this. Elsewhere, fund managers seeking to diversify portfolios have increasingly turned to inflation-linked bonds. Overall, the risk/reward profile of inflation linked bonds have proved to be very attractive to several different categories of investors.
Meeting rising demand for inflation linked products have been institutions whose revenues are linked to inflation. Although this has largely been governments, both supranationals (quasi government issuers) and companies have also entered the market. All three types of issuers have been able to take advantage of the increasingly diverse investor base that is interested in the asset class and concerned over long term inflation prospects. Within the corporate sector, issuance has been seen particularly from utilities, where revenues are linked to price controls, and retailers. Companies participating in public/private initiatives are also issuing inflation-linked bonds as once again, their revenues are linked to future inflation.
Convergence and Future Market Developments
Over the past decade, the global economy has become much more a single global market place than a collection of individual market places. As part of this globalisation, economic cycles in the world’s major economies have become more synchronised. In addition, a trend for central banks to target set inflation rates has developed, and this now forms a key part of the monetary setting policy process.
One of the results of these factors has been the convergence of inflation rates between developed nations. The fact that inflation rates in the UK and Continental Europe, and inflation rates within the Eurozone nations, have been converging over the past five years provides a good example of the effect of central bank inflation targeting. As of 1st January 1999, the European Central Bank’s key mandate has been to target inflation of 2.0% as measured by the European HICP. In the UK, since the Bank of England was granted independence from the UK government in 1997, it has targeted inflation of 2.5% as measured by the UK RPIX. Since 1999, inflation rates between the UK and the Eurozone have converged significantly compared to previous trends. Looking ahead, with the Bank of England’s inflation target moved to 2.0% as measured by the UK HICP in November 2003, UK and Continental European inflation is likely to converge further. In addition, inflation rates for Eurozone member countries are likely to continue to converge as the Eurozone economies become more synchronised.
Initially, the French government only issued OATi’s linked to French inflation, however, it now issues OATei’s that are linked to core inflation across Europe. Going forward, we may see more countries, particularly within Continental Europe, entering the inflation-linked market and issuing bonds linked not only to their domestic inflation rate but also a more international measure of inflation. The more that inflation rates converge, the more appealing the idea of issuing a bond linked to an international measure of inflation will be to governments. Rising issuance and increasing varieties of inflation-linked bonds would be positive for liquidity. On the buy side, the greater the liquidity and breadth of the market, the more attractive the asset class should become to investors.
Opportunities to Add Value
In addition to the benefits of gaining a real return, or a return that is not hurt by inflation, actively managing an inflation-linked portfolio provides investors with the opportunity of having extra value added to their investments – the opportunity to beat an index or benchmark. Starting from the initial assumption that markets are inefficient, which include inflation-linked bond markets, an index can be beaten by correctly identifying inefficiencies and adjusting a portfolio to benefit when the market corrects the inefficiency.
There are various ways in which F&C seeks to outperform a benchmark when managing an inflation-linked bond portfolio. The duration of a portfolio can be, depending on whether prices are expected to rise or fall. Long term value models and short term timing tools can be employed to identify whether a portfolio should be short or long in duration. In addition, positions can be taken along the yield curve – for example, an overweight in long dated securities and an underweight in medium dated securities could be implemented if yield curve modelling analysis or security modelling analysis suggests that this would be prudent.
In a bond portfolio that also holds conventional bonds, asset allocation decisions can add value by taking an overweight in inflation-linked bonds versus conventionals, or vice versa. Similarly, with the corporate inflation-linked market in existence, it is also possible to trade off the difference between government bonds and corporate bonds. For portfolios that hold an international basket of inflation-linked gilts, asset allocation decisions can be made for each different country depending on forward inflation modelling for each country. However, the opportunity to take advantage of inter-country differences in inflation rates may decline going forward as inflation rates converge.
In summary, there are a number of ways in which the active management of inflation-linked bonds can enhance the return that they provide. Of course, an actively managed portfolio also carries the risk that performance could fall short of index returns if the wrong strategic decisions are made. However, if a portfolio was passively managed, or tracked an index, it would carry a lower risk but would not offer investors any opportunity to add extra value.

F&C’s Capability
At F&C, we manage a range of both global and regional inflation-linked bond portfolios. We have a highly experienced dedicated team of professionals investing more than e3.5bn, making us one of the largest active managers in this asset class.

Paul Grainger is a Director and Investment Manager, having joined F&C in 2003. Paul manages UK bond portfolios. Paul graduated from Exeter University in 1995 with a degree in Economics with European Studies and is a CFA Charterholder. Paul began his career in September 1995 on the Barclays de Zoete Wedd graduate training programme. Prior to joining F&C Paul was responsible for managing the majority of Gartmore Investment Management’s UK bond funds (gilts, investment grade credit and high yield)

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