FRANCE - European pension funds can now invest in French inflation-linked government bonds and reduce exposure to interest rate volatility thanks to the introduction of bond stripping.

CNO, the French Bond Association, has approved a calculations system which will ensure once bond stripping is introduced there is no financial detriment between those who buy the zero coupon bonds and those who buy a strip holding the interest payments.

This development is said to have come on the back of demand from pension funds which need to buy long-term zero coupon fixed income debt to help meet their future benefits liabilities or want to counter inflation risk through the purchase of strips.

It should mean pension funds will separately have access to Obligations assimilables du Trésor (OAT) or French government bonds, and Bon à Taux Annuel Normalisé (BTAN) or the coupon earned, and can preserve their long-term liabilities against the need to offset interest rate fluctuation.

Under bond stripping, the interest payment or coupon of a bond is separated as a new form of bond - in this case the BTAN, leaving the original fixed income debt as a zero coupon bond, creating a new supply of zero coupon bonds and strip bonds.

A strip bond then has no reinvestment risk because the payment to the investor only occurs at maturity while each zero coupon bond is set as having a base value of 100, therefore repaying the original sum borrowed at maturity.

CNO has been looking at developing a bond splitting market since 1991 but had to wait until it felt there was sufficient liquidity in the inflation-link government bond market to make it feasible.

"With a monthly average of €37bn of transaction reported by primary dealers Spécialistes en Valeurs du France Trésor (SVT) in the secondary market in 2006 and an outstanding of €111bn at the end of 2006, Agence France Trésor [the issuer of government bonds] now judges that the liquidity of inflation bonds is now significant enough to authorise the stripping of these securities," according to ONS.

From Monday, June 25, bond stripping will create inflation-linked zero coupon bonds of anything from one month - ending on July 25, to July 25, 2029 on the French inflation-linked real rate curve and to 2040 on the European inflation-linked real rate curve.