In Europe, it seems pricey to buy inflation, whether for liability-hedging or simple wealth preservation. Brendan Maton looks further afield
Going, going, gone. In the space of five months last year, real yields on UK government inflation-linked bonds shrivelled to nought. From a miserly 0.59% on 30-year swaps mid-April, the yield went negative in September and has rallied little since.
You may not wish to join those in the queue for this kind of deal even if you do believe that for the next 30 years UK inflation is going to average 3.22%. That was breakeven inflation, supposedly the market’s best guess about how inflation will pan out, on 1 December.
“The first problem is that through quantitative easing, the Bank of England will own approximately one-third of the conventional gilt market by February - it could be more,” says April LaRusse, senior product specialist at Insight Investment. “That has skewed the relative value between conventional gilts and index-linked gilts, as the Bank has not touched the latter. The problem there is that everyone, not just the Bank, has been shocked by the persistence of high inflation in the UK.”
In other words, neither rely on breakeven inflation as a guide for action, nor expect others to. Which might explain why some pension funds, for whom inflation accounts for the majority of risk to their liabilities, continue to buy linkers at such apparently high prices.
“The attraction of domestic linkers and swaps is the ability to mark to market the changes in the liabilities, such that sponsors don’t suddenly find themselves facing an unwelcome cash-call to top-up the funding after the actuaries do their sums,” says Stephen Booth, global head of fixed income derivatives at Aberdeen Asset Management.
This sounds like a victory for the accountants and investment principles. But as a cure for the purchasing power puzzle, PIMCO, a major bond manager, is proposing UK funds widen their horizons to include inflation-linked bonds from other states, including Brazil and Mexico. PIMCO’s GLADI index reduces the weighting of the US from 39.5% in a conventional index of inflation-linkers to 25.6%, and France from 12.8% to 7.2%. The big change, however, is the UK’s weighting being cut, from just over one quarter, to 5.7%.
Conventional bond indices weight issuers by outstanding debt. The more capital a state or company borrows, the greater its presence in the index. At the end of 2000, before it reneged on sovereign debt repayments, Argentina comprised 23% of the JP Morgan Emerging Markets Bond index. PIMCO, Barclays Capital, Research Affiliates and other new index providers suggest that it makes more sense to weight constituents according to their GDP - thereby going some way to recognising issuers’ ability to repay their debt.
But pension funds chasing index-linkers can go one stage further, according to Jeroen van Bezooijen and Berdibek Ahmedov of PIMCO. They reckon GLADI provides greater connection to foreign causes of inflation - namely energy, food and other commodity prices - which are likely to make a larger impression on UK inflation in years to come. Indeed, they say this is already under way: food and fuel items, which together make up about 15% of the UK’s RPI inflation basket, has caused about one-third of the cumulative inflation between 2005 and 2010. Conversely, the influence of strongly domestic factors such as housing is waning.
The big task is not merely to make the connection between emerging markets (EM) and inflation protection - after all, retirement plans all over Europe have been attracted more and more by direct exposure to EM debt. PIMCO wants them to go further and loosen their definition of liability-matching investments, so that Brazilian and Mexican debts, for example, could be placed there rather than in the return-seeking bucket.
Van Bezooijen and Ahmedov’s sales pitch is that even a dose of 7.5% of GLADI added to a defined benefit scheme brings better returns for little more risk than UK linkers alone would provide - and a better outcome than no linkers at all.
There are quibbles with any example; this one compares RPI-linked UK debt with mostly CPI debt globally, which favours the latter by roughly 0.5% in terms of return, according to Rob Gardner, co-CEO at Redington Partners. Van Bezooijen responds that even after factoring this in, UK linkers look expensive.
Support for the general diversification argument comes from Laurens Swinkels, senior researcher in the investment solutions team at Robeco. In a new paper, he calculates that EM linkers provide greater diversification than nominal bonds and developed-market bonds alone.
But the Dutch experience of purchasing linkers abroad is itself a cautionary tale. Some pension funds put up to 20% of their total capital in sovereign linkers issued by other euro-zone members (the Netherlands does not issue inflation-linked bonds). “[Today] the credit risk is so great in ILBs from Greece, Italy, and even France that the inflation-protection feature has been demoted,” says Swinkels.
The story of Europe’s PIIGS could be seen as a reason to either shun the PIMCO advance or welcome it. Mexico, for example, has been running steady inflation of 5% for almost a decade. But this country has also suffered major shocks in the past. So which foreign holdings are appropriate for the payment of UK or Dutch liabilities?
“Emerging market linkers are in a completely different cycle to the UK,” says Jerome Booth, head of research at Ashmore, which operates an Emerging Markets Inflation-Linked Bond fund. On a short view, he sees no correlation. But if one looks 15 years in the future, the story alters. Booth reckons linkers play a part alongside other EM instruments in matching UK pension liabilities because so much of the typical UK pensioner’s consumption will be priced in countries like Brazil and China.
“At some point the regulators are going to have to take into account purchasing parity,” he suggests. “Until then, I suppose it is still possible for corporate sponsors to meet their regulatory obligations even if, in real terms, pensions [over the] long term won’t be able to buy a loaf of bread.”
HSBC Global Asset Management lands somewhere between Ashmore and PIMCO in this debate. It finds that UK RPI shows a 79% correlation with world inflation between 1997 and 2010, while the euro-zone exhibits a 77% correlation. This should please those pension schemes looking for something approaching a match, but there is more. Hedging into sterling, the Barclays World Government Inflation-Linked Bond index has outperformed its UK peer by 0.5% annualised, with 0.8% less volatility, over the past 13 years. While HSBC Global AM invests in emerging markets linkers, Chris Gower, head of consultant relations, still feels this is more of a growth story and, instead, promotes the current global universe (optimised by active management) as the better solution for those UK funds that cannot afford to buy domestic linkers at any price.
Kevin Frisby, a partner at the London-based consultancy Lane Clark & Peacock, suggests the best way to loosen the divide between liability-matching and growth-seeking assets is to buy inflation swaps and put the freed-up capital to work in higher-yielding assets. Pension funds seem to be listening: according to RBS, 41% of UK liabilities are already hedged with RPI swaps, as opposed to 40% hedged by cash-market linkers. But there might be a tactical incentive too. Like LaRusse, Frisby is conscious of the strange effect quantitative easing has had on relative prices between nominal and real bonds: “If people think linkers are pricey, they should have a look at nominal yields.”
If this imbalance reverses, then break-even inflation ought to increase. Therefore, in spite of high absolute inflation levels, now might be a fair moment relatively for investors to enter into an inflation-only swap. Of course that leaves the problem of where to make the rest of the capital sweat - but at least the major headache of inflation in liabilities is diminished.