For an economy which has roots deeply entwined with the destructive nature of inflation, it may come as a surprise to hear that Germany’s capital market is becoming increasingly active in the development of an inflation-linked bond yield curve.
Inflation-linked, or indexed, bonds – colloquially known as linkers – are typically issued by sovereigns, agencies and occasionally utilities, to raise debt capital as part of their treasury funding calendar. Investors, especially pension funds, are opting for them because they provide diversification, a relatively low correlation with other asset classes, some arbitrage opportunity and can form part of a hedging strategy.
Linkers pay a coupon that is equivalent to the sum of the increase in an inflation index (usually the consumer price index, or CPI) and the real coupon rate. A rise in coupon payments is a result of an increase in inflation expectations, real rates, or both.
According to data from fixed income research at investment bank Calyon, the volume of euro-denominated linkers notionally traded has risen from €2000m ($3106m, £1564m) in 2004 to €6000m this year.
The UK first issued inflation-linked gilts in 1981 and the market is now worth £300bn in outstanding notes. The US equivalent, Treasury Inflation-Protected Securities, is the most liquid market, at $500bn. In France, the Agence France Trésor, issues OATi (Obligations Assim-ilables du Trésor) or OATEI, which are bonds indexed on eurozone price inflation.
Frontier markets
But it is the frontier linker markets in Sweden, Canada and now Germany, which are giving market-makers just cause that, as one fixed income investor puts it, “inflation-linked bonds are becoming the bond class of the year”.
And liquidity in Deutschland is legion, local issuers and investors argue, with a yield curve stretching along the full range of maturity points. Dr Carl Heinz Daube, managing director at the German Finance Agency (GFA), explains that his role, he’s in charge of raising capital for the Federal Republic of Germany and has €925bn in liabilities under management, is getting bigger every day. “We were the last country to start linkers (of the larger players in the Eurozone) so we’re playing catch up. Now we need to achieve a high level of liquidity in linkers ranging €12-15bn in size so over the next four years we can have a complete maturity curve,” he says.
The GFA currently has €17bn in linkers outstanding, having brought to market its 10 and 5 year notes in 2006 and 2007 as a test to see if investors would buy government debt indexed to a relatively benign inflation index, a scenario which was ultimately successful for Dr Daube. “Our roadshows were helped by being able to reach a different investor base than before. This time it was pension funds from the west coast of America and Asian institutions showing interest in inflation-linked products as both a hedging tool and yielding some alpha, and with lower volatility than other sources of absolute return,” he adds.
By 2012, the GFA will be looking to complete its linker curve stretching from one year to 40 years maturity, and also broadening its international investor base. But the absence of linkers from the Agency’s 2008 issuance calendar reflects two facts: relative liquidity is insufficient across the continent to sustain an obvious government debt programme (the issuance diary is booked up with €213bn worth of bunds and treasury notes), and investors need further education about the diversification/hedging uplift that linkers can bring.
“Pension funds are more sensitive to inflation than the rest of the investment community,” explains Frédéric Prêtet, inflation strategist at Calyon. “We have ample room for more issuance but the market is still constrained – it needs education and more issuance from sovereigns.”
One major investor in inflation-linked products believes they remain underrated, but will gain prominence when the credit crisis comes to an end, and inflation becomes an issue again. “We are convinced that at inflation levels of 3.5/3.6 per cent in the Eurozone, the power of linkers is underestimated,” says Stefan Wolpert, head of euro aggregates at Axa Investment Managers, which has €300m allocated to such notes.
Though currently viewed as a benign force in the UK (3 per cent), the US (4.0 per cent) and Eurozone (3.30 per cent), year-on-year increases in the CPI will play into the hands of the linker marketplace, particularly if the re-inflationary policies of central banks continue. “Inflation may become a huge problem,” Mr Wolpert warns, “and mutual funds and pensions will be flying into products offering a hedging solution and the potential for a few basis points in return.”
But what about sacrificing spread to buy a linker issued in Germany, assuming flows of liquidity continue to be modest within the marketplace, relative to other bond products? “We are a French player and linkers are already an important part of the bond asset class for us,” argues Mr Wolpert. “Adding them to our portfolio makes sense – a little bit of alpha but with volatility not as aggressive as other assets.”
Covered bonds
Germany is also playing a major role in supporting liquidity in covered bond transactions, a product a with far longer track record than the linker market but one that is suffering from wider credit problems in the banking sector. A flow of private deals in the pfandbriefe market, Germany’s longstanding jumbo (€1bn plus) covered bond regime, has kick-started the issuance calendars of a number of savings and property finance firms in recent weeks. The public market remains largely inactive however.
“We are seeing a silent book building process at the moment, with issuers looking more realistically at what they can get out to the market,” confirms Marcel Kullman, head of funding at Eurohypo, Europe’s largest commercial real estate bank. The bank is currently putting the finishing touches to a 5-year euro benchmark public sector covered bond, which had been cancelled a week earlier because, according to Mr Kullman, “the transaction wouldn’t have been a success at the existing spread…it didn’t make sense given the quality of the asset pool and the issuer”.
Other German-based issuers are naturally sympathetic with Eurohypo’s latest issue with covered bond pricing. Marcus Chromik, head of primary capital markets, Deutsche Postbank, the €190bn finance house, says international investors are increasingly tuned into how good the business models and asset pools of the issuer are, before they buy their debt, and this obviously impacts on the spread. “We tell investors we are investor-driven and have enough quality assets in the pool. In the case of international institutions, they are more focused on business models than domestic investors who know what we are about but need to know scenarios and strategies,” says Mr Chromik. Deutsche Postbank has completed a number of private placements and says it is committed to building up a benchmark curve for mortgage pfandbriefe deals in 2008-09.
“Private deals are the backbone of pfandbriefe today,” concurs Mr Kullman, which is particularly relevant given the mortgage-backed securities market, where Eurohypo was once very active, is now a waste ground for the market-maker.
 | Horst Bertram, head of investor relations at Bayerische Landesbank, gives us an insight into what investors are demanding at roadshows when he takes a bond issue to the market. “We are certainly revealing more to investors - more information, what’s in the asset pool, and whether we have a successful business model” |
VDP RINGS CHANGES
The VDP, or Verband Deutscher Pfandbriefbanken, is the association of German bank issuers, and has made strides since the beginning of this year to boost price transparency in the jumbo covered bond market through a series of regime changes. The introduction of an electronic trading platform is one area the VDP and its members are eager to see happen. “The market is extremely strong and in better shape than rival products currently traded,” reckons Volker Walz, head of funding and liquidity management at Hypo Real Estate Bank. “However, we need to be open with investors and get liquidity back in the market. We’ve started discussions about electronic trading platforms and German issuers are at the forefront of this,” he adds.
But for all the bullish talk about private deals lubricating the jumbo market, growing issuer transparency, and the potential for the market to drag itself into the 21st century through the use of e-trading, concerns remain about whether Germany will feel the drag created by the less liquid output of rival covered bond markets. “The ability of issuers to fund themselves is now the crucial question,” claims Heiko Langer, covered bond analyst at BNP Paribas. “The market has turned 180 degrees in credit quality and business models, and pfandbriefe has benefited from this, certainly compared to Spain or Ireland,” says Mr Langer. “The higher premiums we now see is a sign we’re in a buyers’ market, however, for all the book-building and smaller order books, the market can’t de-link from other banking products at the moment. We are seeing a re-pricing of spreads and adjustment to the overall market as a consequence.”
