Linkers and inflation outlook

Not viewed as the most exciting of assets for many years, index linked bonds seem to be undergoing something of a renaissance these days. While performance might have dropped off somewhat this year, during 2003 and 2004 most index linked bonds outshone their conventional, nominal bond peers.
“Though we are pleased that our sector has done well, we would be the first to admit that not all the relative outperformance was due solely to the fact that they were index linked bonds,” says CSAM’s Benno Weber. “During 2004, it was mainly because of their long duration. The index linked bond market is still concentrated in bonds with long maturities and so profited more than the average nominal bond from falling real yields.”
Laurent Gonon at AXA Investment Managers agrees, adds: “Index linkers were performing really well until the beginning of this year when inflation expectations turned down. Greenspan has been telling us that all is under control and by raising rates again and again he’s been acting on his words, so the market turned its attention away from worrying so much about inflation.”
Joseph Moody, an index linked specialist based at SSGA, focuses on the UK market and here too, arguing the market is perhaps fairly priced. He says: “However, with nominal rates so low, we argue that actually investors might want to seek some protection. But of course real yields are also very low, which itself may pose risks. Until recently our view would have been that inflation has generally been well contained with talk of deflation around. At the moment the swaps curve doesn’t quite agree with the cash bonds and prices a premium at longer maturities. The physical market thinks that inflation will be lower than the (inflation) swaps are implying.”
Gonon argues that, although a pick-up in inflation is unlikely, it is right to be cautious. “We now believe the risks are skewed towards inflation being higher rather than lower than our central forecasts.”
“We think that the recent underperformance of index linked compared to nominal bonds has left the spread tight enough so it is no longer expensive to switch back to linkers. At the 10-year maturity, in Europe, there is a spread of just over 2% and we think this is a fair price to put on inflation over the next 10 years. Index linked bonds tend to outperform when yields generally are rising and we are overweight with respect to nominal bonds.”
In the longer term, the outlook for the index linked bond market seems set pretty fair, from a favourable macro-economic viewpoint, an increasingly positive demand side of the equation and a fast improving supply/liquidity situation.
Weber says: “In terms of the secular trend in underlying inflation, we are likely to see a change. If we look at the euro-zone, the underlying trend for inflation has been 2% since the signing of the Maastricht Treaty. We argue that the long-term equilibrium inflation rate is set to rise. If we consider what happened in 2003 when the developed economies came close to slipping into a deflationary environment, there has been much less talk of the dangers of a return to 1980’s style inflation and more open concerns about the potential damage caused by falling prices. Even Europe’s normally critical voices have been much quieter while Euro-zone inflation has crept above 2%. We are not suggesting that the rise will be hugely dramatic – euro-zone’s long-term trend rising to 3%, that in the US trending up from 2.5% to nearer 3.5%.”
It is hard to disagree with index linked managers when they argue that demand for their asset class will increase. “As we see more focus on liability matching, it is clear that more savers, with future liabilities linked to inflation, will want to see their savings linked too,” says Gonon. “The over-riding need is to protect the purchasing power. In the past equities or real estate might have been used, but perhaps not so much in the future. And investing in index-linked bonds is another useful way to diversify assets as they (linkers) can lower volatility and improve expected returns.”

The advent of inflation linked derivatives markets in the US and most especially in Europe has provided a significant boost to this erstwhile illiquid asset class. According to Alan James, of Barclays Capital Research, one of the major benefits of derivatives over the cash bonds is the flexibility they offer to suit specific needs of both he buyers and sellers of inflation.
The liquidity of the inflation linked swaps market and that of the underlying cash market are closely related as dealers can use cash flows from one market to hedge those in the other, a true virtuous circle. And inflation swaps trades are already happening in countries such as Germany, Spain or The Netherlands despite there being no government inflation linked supply.
Since 1945 a number of countries issued inflation linked bonds, including Israel, Argentina, Brazil and Iceland. However, the modern market for index linked bonds (or linkers) was born in the early 1980s when the UK Treasury issued its first index linked bond, and for many years was treated as a rather quirky and pretty illiquid market. Over the last decade more countries have been issuing linkers, including the US and France and Italy. According to Barclays Capital, the size of the (global) linker bond market more than doubled between September 2002 and January 2004 to $500bn (e412bn).
During the last decade, more governments have been issuing these bonds, thus increasing the geographical range of bonds available and also the requirement for a global index covering this range of markets, allowing investors to compare different markets. Although the FTSE-Actuaries British Government Index Linked Securities Index was first published back in 1984 (with a base date of 30 April 1982), and is still a very popular choice of index among investors in the UK market, global indices did not appear until the late 1990s.
The current Barclays Global Index Linked Bond Index (BGILBI), launched in 1997, is made up of liquid inflation linked government bonds from 11 different countries including the US, France, Italy, Canada, Australia and Greece. The UK’s share of the global index has been reduced from just below 80% when the index was launched in 1996 to around 31% today, behind the US with 42%. The share of the euro-zone has now grown to 16% in January 2004, with the combined issuance from France and Italy (and not forgetting a stronger euro of that period). At the end of 2004, the Index was $680bn, and Barclays expects it to exceed $1trn in 2006.
Barclays inclusion criteria include a minimum credit rating of a government’s foreign debt (AA-/Aa3 or better), and a minimum market size (under $500m). There are thus several other index linked government bond markets not included in the Barclays Global Index. They include: Israel, South Africa, Mexico, New Zealand, Greece and Iceland. Greece is in the euro index, and there is a stand-alone index for South Africa. Japan issued its first index linked bond in March 2004, but it is not in the Barclays index due to holding restrictions on the initial bond. There will be a stand-alone Japanese index until the restrictions are relaxed.
The market capitalisation for euro linkers has grown from E4.3bn in 1998 to E7.4bn at the end of 2003.
The euro non-government inflation linked bond market is still small, and is dwarfed by the sterling non-government bond market which has a 81% share of the total non-government inflation linked bond market, at the beginning of 2004.
Reference: ‘Inflation-Linked Products – A User’s Guide’. Barclays Capital Research, January 2004.
Barclays Inflation-Linked Bond Indices. Barclays Capital Research, January 2004

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