Inflation-linked ETFs can play an important part in protecting the value of a portfolio. Lynn Strongin Dodds reports

In the past two years, exchange traded fund (ETF) providers have launched inflation-linked bonds as part of their full fixed income offering. As food and oil prices continue to soar, these products are becoming increasingly popular as institutional investors look to hedge their inflation risks.

It is no surprise that European investors are concerned about inflation. The US Federal Reserve’s repeated rate cuts aimed to stimulate the US stalled economy has fuelled worries that global inflation will accelerate over the coming months. In the 15 nation euro-zone, the latest statistics reveal that consumer prices surged in March to the highest level since the bloc was formed in 1999, according to the EU’s Eurostat statistics agency.

At the moment, The European Central Bank (ECB) is walking a fine line between setting interest rates at a level that will jump start the euro-zone’s economy while at the same time keeping prices in check. For now, the ECB, which traditionally has been more focused on inflation than the Fed, has decided to keep euro-zone rates on hold at 4%. This, though, may not hold price hikes at bay, and investors are likely to seek cover in inflation-linked products.

In fact, this year European governments were able to sell a record €54bn of index-linked bonds (which provide protection against inflation), up 20% from €45bn last year, according to the median forecast of seven of Europe’s 10 biggest debt-trading firms surveyed by Bloomberg. Inflation protected bonds behave differently from other types of bonds in that the coupon and face value of the bond are automatically increased at regular intervals to compensate for inflation, by tracking an inflation index. In the UK, for example, this is typically the UK retail price index (RPI) and in the US, it is the consumer price index (CPI).

While some of the inflation-protected bonds may currently be priced over par, the cost is typically offset by the fact that these bonds tend to outperform regular bonds when projected inflation rises. This is particularly the case in the US where the demand for Treasury-Inflation Protected Securities (TIPs) has dramatically risen since the end of February. Prices for five-year TIPS have jumped to more than 108% of par value, pushing real yields below 0% or close to that level. The real yield - or yield to maturity - takes into account the bond’s sale price and interest payments over the bond’s life. A negative yield means that investors are paying more up front than they are expecting to receive from the coupon rate, or the basic interest payment promised at issuance.

The main appeal of TIPS is that interest payments are linked to changes in the labour department’s CPI. If that index rises, so does the US government’s payouts to its bondholders, which raises the bond’s value at maturity. By buying TIPS with negative yields, investors are relinquishing money upfront in exchange for insurance against future inflation.

JR Rieger, US-based vice-president, fixed income indices at Standard & Poor’s, says: “The price changes reflected by indices such as CPI and RPI are proxies for measuring inflation. Investors in inflation-linked securities need to determine if the index used by that security generally reflects the inflation risk they are most concerned about. There is no doubt that with the current global scenarios, inflation-linked bonds can play an important role in preserving the value of a portfolio. Investors are looking to improve their risk/return profiles and the attraction of an inflation-linked ETF, for example, is the diversification it offers in terms of issuers, credits and currencies. However, they should be viewed as part of an overall fixed income investment strategy.”

Inflation-linked ETFs made their debut in 2005 when Barclays Global Investors’ iShares brand and Lyxor launched their products. The iShares € Inflation-linked Bond ETF tracks the Barclays Euro Government Inflation-linked Bond index, which currently includes bonds from France, Germany, Greece and Italy. The iShares £ Index-Linked, which made its debut in 2006, follows the Barclays UK Government Inflation-Linked Bond index which provides exposure to a diversified basket of UK government investment grade of all maturities. The same year also saw the introduction of the iShares $ TIPS1, which tracks the Barclays US Government Inflation-Linked index, a diversified basket of inflation-linked bonds issued by US government. Together, assets under management for all three are €650m.

Alex Claringbull, (pictured right) senior fixed income portfolio manager at iShares, notes: “When we first launched the inflation-linked euro product, investors did not just want exposure to the juiciest, most exotic instruments but access to the full suite of fixed investment products including the basic vanilla-type of bonds, to better optimise their portfolios. Recently, investors have been looking at their risks and with inflation in the headlines everyday we are seeing a greater demand for inflation-linked products. However, it is also a reflection of a general increased usage in fixed income instruments. This is because the equity markets have been volatile and institutions are looking for safer havens.”

For now, the fixed income ETF market is relatively small but iShares expects assets in these products to surge by more than 200% over the next three years, from around $60bn at the end of January 2008 to over $200bn. Today, fixed income funds account for 7.5% of the total ETF market, which today stands at about $800bn (€503bn). US investment bank Morgan Stanley predicts that figure to reach over the $2trn mark by 2011.

As for inflation-linked ETFs, there are still only a handful of products on the market although this might change if inflation continues to climb and providers want to fill in the gaps in their product ranges. The largest users of fixed income on the institutional side, according to Dan Draper, global head of Lyxor ETFs, are funds of funds as well as pension fund managers involved in balancing a portfolio across a range of different asset classes. “The biggest demand we are seeing at the moment is for our cash products such as the The Lyxor ETF Euro Cash EuroMTS Eonia Investable, although inflation has definitely become a bigger issue. Investors in the euro-zone are becoming more conservative and they are looking to include inflation-linked ETF in their portfolios for hedging purposes.”

Lyxor’s ETF EuroMTS Inflation-linked product, which has €417.45m of assets under management, follows the EuroMTS Inflation-linked index (EMTXi), which measures the performance of the euro-zone’s inflation-linked sovereign debt. Unlike some of its competitors, Draper says “Lyxor has no plans to launch a sterling or global product but we are likely to do more in the cash space.”

Deutsche Bank, on the other hand, took the decision to have the full set and last year, introduced a euro and global inflation-linked ETF, with a sterling product to follow this year. Manooj Mistry, head of db x-trackers structuring, notes: “Our philosophy is that we want to offer as wide a product range as possible and the inflation-linked ETFs are part of the toolkit. These products do not only provide an effective hedge against inflation but they also offer the ability to participate in global economic trends. Our global ETF, for example, is the most popular of the inflation-linked products because currently investors are most worried about global inflation on the back of rising food and energy prices.”

The global ETF, with €230m AUM, follows the iBoxx Global Inflation-linked Total Return index, which covers the major sovereign and quasi sovereign inflation-linked bond markets while the euro product, with €50m AUM, tracks the iBoxx Euro Inflation-Linked Total Return index which encompasses the major euro-zone currency sovereign and quasi-sovereign inflation-linked bond markets.

The latest offering in the inflation-linked world emanates from State Street, which this past March introduced the SPDR DB International Government Inflation-Protected Bond ETF, which tracks the Deutsche Bank Global Government ex-US Inflation-linked Bond Capped index. It includes 120 inflation-indexed bonds from 18 developed and emerging countries outside the US. Bonds must be capital-indexed and linked to an eligible inflation index and have at least one year remaining to maturity. Other requirements include a fixed, step-up, or zero notional coupon; and settlement on or before the index rebalancing date.