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Special Report

ESG: The metrics jigsaw

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Oati, the Euro way to inflation protected bonds

At the beginning of the 21st century, nominal rates have fallen to historical lows. And yet 20th century investors and savers cannot forget the devastating effects of inflation. Monetary erosion amounted to 7% per year on average in France; it destroyed the buying power of pensions after the Second World War and cropped up again twice during ‘The Great Oil Crises’. At the end of the 20th century, central banks proved their credibility and efficacy with the creation of the euro and the coordination of international economic policies. The launch of inflation-linked bond by Margaret Thatcher’s government at the beginning of the 80’s when inflation was at a peak level was a bold way to announce that price instability would be fought with determination. Other countries like Canada and in Europe, Sweden, where pension funds exist have followed. Inflation-indexed contracts were forbidden in France for a long time until the government first issued inflation-indexed bonds in 1998 after the US. Since then, other issuers such as the French body CADES, a motorway concession holder and a bank have issued French inflation-indexed securities and the government has broadened the base of its debt holders by indexing on European inflation.

What is an OATi ?
OATi stands for ‘Obligation Assimilable du Trésor’, a fixed-rate Government bond indexed on inflation. The bond’s principal is indexed on inflation from the issue date to the maturity and the coupon is a constant percentage paid annually. In the case of French bonds, inflation is based on two references: the French consumer price index excluding tobacco for OATi bonds and the Euro-zone consumer price index, excluding tobacco, for the new OATei bonds.
In fixed-income markets, inflation-indexed bonds are priced ex-inflation or on actuarial yield, also called ‘real rate’. This real rate is generally lower than a classic fixed-rate bond’s nominal rate and determines the bond’s return in an inflation-free universe. The part corresponding to the change in inflation, which is capitalised in the indexation coefficient, is added to this remuneration.

How to compare an OATi with a classic OAT?
The difference between the nominal rate and the real rate on a given maturity, also called inflation break-even point, is used to measure the attractiveness of inflation-indexed bonds compared with classic fixed-rate bonds. Market players interpret this difference as the expected inflation over the period. If the inflation realised over the period is higher than the break-even point, an OATi holder achieves a better return than the holder of a classic OAT of same maturity. Obviously, the narrower the spread, the less inflation expected by the market, and the cheaper the protection against the risk of inflation.
Given the specific structure of an OATi’s flows, ie, reduced real fixed coupon and capitalisation of all inflation upon maturity, the duration of an inflation-indexed bond is longer than that of a classic bond of same maturity. Additionally, these securities are generally held by final investors for medium- to long-term periods, thus reducing the volatility of real rates compared with nominal rates. Statistics show that an OATi is half as volatile as a classic OAT. The correlation between OATi and OAT is low and that between inflation-indexed bonds and equity markets is slightly negative.

A new asset class:
Inflation-indexed bonds now make up an asset class per se, differing from other traditional asset classes such as money market instruments, bonds and equities. They offer the best protection against possible monetary erosion of capital whilst combining a performance comparable to that of classic bonds with low volatility. These securities also offer protection against the risk of deflation. The capital guarantee is only valid if the securities are held until maturity. Conversely, before maturity, their prices fluctuate according to supply and demand and to market expectations on trends in interest rates and inflation. This new asset class provides portfolios with a true diversification possibility.

When is the right time to invest in OATi?
The remuneration of an inflation-indexed security consists of a real return and a return based on inflation over the investment period. Buying opportunities must therefore be appraised in the light of the level of the real rate as well as that of the inflation break-even point that measures the market’s expectations for future inflation. According to certain economists, the real rate should be compared with potential growth that is currently estimated by the European Central Bank at 2% to 2.5% for the Euro-zone. When inflation represents a high risk, the market pays a correspondingly high premium to hedge against it; the inflation break-even point is wide and offers less upside potential compared with classic bonds.
As a result of the current bond rally, underpinned by lasting geopolitical tensions and a deteriorating economic environment, nominal and real rates have dropped to historically low levels. Real rates are at 1.5% to 2.9% with inflation break-even points between 1.5% and 2.25%. The real rate and inflation break-even point curves are very steep, giving long maturities a major edge. As is the case for nominal rates, risks also depend on the investment horizon. This asset class, however, must be examined according to other criteria:
n risk diversification in a portfolio;
n hedge against inflation in the medium- and long-term;
n profitable bond investment offering real return plus return on inflation;
n hedge against a possible bond correction in the case of an economic recovery.

Who can invest?
These characteristics are very attractive to all institutional or private investors. Institutional investors will find an asset-liability financial instrument, backing structurally inflation-indexed liabilities such as pension commitments, life or health insurance contracts as well as all contracts providing for material damage, typically in the building industry. Private savers will find an ideal asset to preserve and increase the buying power of their retirement savings. They will also be able to hedge their projects, notably housing plans, against the risk of overspending. Moreover, since this asset class is profitable and lowly correlated with other asset classes, it will be a useful addition to diversified portfolios. In what proportions? Studies show that OATi can represent half of the bond component and up to one quarter of assets in a low-risk portfolio.

Growing outstandings:
The overall outstandings of inflation-indexed bonds in euros have increased significantly, amounting to almost E50bn at the end of February 2003 in France and approximately US$400bn worldwide. The French Trésor regularly launches issues in this asset class and now uses both types of inflation-indexed bonds, OATi and OATei. The lastest issue of OATei was bought mainly by more French investors, up to 80%. Other public and private issuers, in particular CADES, RFF, CNA and ALIS (motorway concession holder), are also present in this compartment. Since October 2002, final investors have been constantly adding this asset class to their portfolios. Moreover, demand has increased since the latest change made to the insurance regulation on 24 December 2002, that enables insurance companies to book gains and losses linked to inflation indexation. Since then, the Greek government has issued a bond indexed on Euro-zone inflation. Final investors’ appetite for this asset class is increasing and will certainly ensure that it achieves stable returns, unlike classic bonds that can suffer from excess volatility fuelled by possible geopolitical and macroeconomic crises.
Jean-François Boulier, deputy CIO and Saïd Moualil, senior portfolio manager at Crédit Lyonnais Asset Management in France

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