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This month saw the Bank of Italy follow the central banks of France and Greece into the inflation-linked arena premiering with a seven billion euro five-year inflation-linked bond issue, and it is an asset class that is attracting interest from institutional investors and pension funds across Europe.
Inflation-linked bonds, whereby a real return is promised as the bond’s return is guaranteed to be higher than inflation, are not new phenomena. The UK government started issuing ‘linkers” in 1981, and the US, Australia, Canada and France have also been fans for some time. There are, however, certain characteristics of the current market environment that are especially favourable for investment into inflation-linked bonds, and the extra supply from Italy is welcomed.
Extreme volatility in world markets has resulted in forecasts becoming more like guesswork. While some fund managers are predicting a 10% rise in equity markets over the next year, others equally convincingly foresee a 10% fall. The bear market of the last three years has highlighted the risk associated with wrong predictions as many of the world’s pension schemes have found themselves in deficit, and as a result, they are placing increased emphasis on asset-liability matching and risk reducing. Assurance is the name of the game.
“We’ve learned a few lessons,” says John Brynjolfsson, head of PIMCO’s real return fund. “We now know that taking more risk does not equate to higher returns. For those conservative investors who have doubts about the robustness of equity returns, inflation-linked bonds will be attractive.”
Increased investment in inflation-linked bonds will also come about as a result of consultant and actuarial advice. While it is not a new theory that, for optimal asset-liability matching, a straightforward hedge would be based on inflation-linked and nominal bonds, the bear market in equities of the last three years, has made pension funds sit up and take notice. The idea that equities match the liabilities of pension funds has been accepted as “folklore”, and some pension funds are upping their allocation to bonds. Says Nick Horsfall, of Watson Wyatt: “People are more willing to talk about asset-liability matching and the bond versus equity story now, and more time is being spent on getting bond mix right. Indeed, it is vital to get the mix of government bonds, inflation-linked bonds, corporate bonds etc right.” Horsfall says that UK clients will typically have between 25% and 75% of their bonds allocated to index-linked bonds depending on the benefits they are paying.
For Horsfall, index-linked bonds at the moment are also more attractive than fixed-rate bonds. “Over the last two or three years, the level of inflation priced into fixed interest bonds has been relatively low, so index-linked bonds look more attractive, and we’d now push a higher allocation.”
On the continent, index-linked bonds are also offering value, believes Franck Dixmier, head of fixed income fund management at AGF Asset Management in Paris. “While index-linked bonds are quite expensive, there is a demand element which is creating a positive environment.” In Germany, legislation was passed over the summer that will allow funds to now invest in inflation-linked products, and despite restrictions, Dixmier believes that the increase in demand will increase the value of the asset class.
In France also, demand for the product looks set to increase. New regulations there mean that Livret A will have their performance partly linked to French inflation as of August 2004 which will push demand for index-linked bonds.
Technical factors are, indeed, very supportive for index-linked bonds. Says Dixmier: “Changes in legislation in France and Germany, and Italy’s launch of index-linked bonds lead to natural demand for the asset class. Furthermore with volatility in the market, they act as a good defensive tool in a bond portfolio.”

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