Inflation-linked bonds are set to make a come-back in Japan, with the government planning to issue ¥300bn ($3bn) worth of notes in October after a five year absence from the primary market. Inflation-linked bonds, shortly “linkers”, are starting to become a serious asset class for institutional investors with increasing issuance by governments across the globe: the market value of outstanding linker worldwide exceeded $2.5trn for the first time this year, from less than $500bn only 10 years ago, driven up by both supply and demand.
On the supply side, obviously governments are keen to diversify their sources of funding any way they can to stabilise and safeguard the flow of money financing its debts. The Japanese Ministry of Finance (MoF), tasked with the refinancing of its huge debt pile, therefore hopes to find a new and stable investor base for its debt by linking the redemption payment to the CPI.
On the demand side, investors, with an eye on the huge liquidity created by central banks around the world and the risk that at some point in the future this could create inflation, are keen to hold assets that protect against higher inflation down the road than is currently anticipated.
Japan used to issue inflation linked bonds in the 2004-2008 period, but ceased issuance after the Lehman shock as liquidity dried up and the type of linkers issued by Japan fell out of favour. Japanese linkers at the time did not have a nominal floor, so with the advance of deflation, investors saw the principal redemption amount lowered by negative inflation, rather than marked up.
Clearly this defeated the purpose of the securities for investors and the MoF, this time around, will issue bonds with a nominal guarantee to protect investors against continued deflation. If, however, the Abenomics plan pens out as the government hopes, a 2% inflation rate will mean the nominal guarantee will not cost the government anything in practice. So far however the market does not seem to believe the plan will succeed: private sector investors price-in less than 1% of inflation for the next five years, and a large chunk of that is made up by the consumption-tax hike which seems very likely to go ahead. The rate of expected inflation implied by the Japanese linkers still outstanding should however be taken with a grain of salt. Having reached a peak market value of well above $100bn, buy-backs and non-replaced redemptions have shrunk the market to $35bn. The recent bond-purchasing program by the Bank of Japan has taken another $12bn out of the market so observers have stopped using the break-even inflation rates implied in bonds prices as the market is lacking liquidity and efficient price-formation.
It will therefore be interesting to see how the placements of new linkers in October and January next year develops: will the market price the bonds in line with the government’s target and professed expectation of 2% price increase or remain skeptical that Abenomics will reach its objectives ?
The issue of lesser liquidity and less efficient price formation in the inflation-linked bond market however is not restricted to Japan. Despite the fact that inflation linked securities are a natural asset class to invest in for pension funds and life insurers that have liabilities linked to price- or wage-inflation, linkers are not included in the major bond indices used by institutional investors. This means any buying of linkers are “off-benchmark” making demand more fickle and short term in nature.
Those investors that do take a more strategic allocation, tend not to bother too much and often choose to simply passively track an index. That creates mis-pricings of its own: with most of the money employed tracking an index consisting of only a limited number of securities (14 in the case of Japan, 34 in the case of the US), the inclusion or exclusion of a particular bond creates substantial overbuying and overselling, a feature active investors can take advantage of at relatively limited risk.
All in all the restart of Japan’s linker issuance should be considered a good thing. If investors in Japan’s huge pile of government bonds should have one concern, it is that Abenomics will end up being an exercise of a government inflating itself out of its debt by creating hyper-inflation. Linkers provide some insurance against the government taking such a course. The $6.3bn of issuance planned thus far however, is a drop in the ocean with limited disciplinary effect.
Little incentive is coming from such an amount to prevent the government from eroding the value of its $10trn debt-pile outstanding. Investors might as well welcome the upcoming issue by massively buying the bonds and spur the government to issue more, if only to protect the value of their much more substantial holdings in nominal Japanese Government Bonds.