At the end of August, the UK Debt Management Office (DMO) announced the launch of the world’s first ever 50-year inflation linked bond (ILB). The market had been waiting for the announcement for some time, but the syndicated offering model chosen by the DMO for this new issuance took some by surprise.
Until now, the UK government had always issued bonds by auction, and the reason behind the decision to use a syndicate of investment banks on this occasion are now being debated across the industry.
“We tend to prefer the auction process because it is much more open and transparent, but I can understand why they have chosen the syndication for this issue,” says David Dyer, fixed income investment manager at Axa IM. “They’ve done it simply because they are uncertain about the demand they will get. The 50-year conventional bond issues in the UK haven’t seen a huge demand, so it [the syndicated offering] seems sensible given they don’t know whether there is going to be big or little demand.”
The announcement by the UK government comes at a time when the market for inflation-linked bonds is growing across the world.
At the end of last year, the global ILB market represented over €500bn, and it is expected that figure will double in the next couple of years. Countries like the UK have been issuing ‘linkers’ since the early 1980s and others have joined in over the last two decades. Countries such as the US, Sweden, Canada, Australia and New Zealand started issuing ILBs in 1997, with France, Greece, Italy and Japan joining in more recently.
“The UK has seen a fairly steady increase in inflation-linked bonds over the last four to five years,” Mr Dyer says. “I think we are pleasantly surprised that the sector is growing in Europe and the US as well, and it is becoming more of an international market. Historically investors have very much been concerned with investing to match their own inflation with their liabilities, whereas as it becomes more of a global asset class investors rather than just investing in their own domestic markets will have the opportunity to go more into international markets.”
“UK investors are already very internationally-biased. On the Continent, because in most markets there is a limited supply for inflation-linked bonds, people are also keen to go into European as well as domestic products. It is more of a necessity,” he says. This way, he explains, French investors for instance have been investing in both European and French ILB, the same way that countries where ILBs haven’t been issued as yet, such as Germany, have been investing in other countries.
Too few issuers
At Baring Asset Management, sales director Nick Davidson agrees with this view. “Outside the UK, the pick up of linkers has been much more recent, and the harmonised euro inflation index, which is now used in some countries like France, is also very recent. One of the problems is that there are very few issuers” he says. “In Holland, for instance, investors are a little bit nervous about buying into an euro linker that may have an exact correlation with French inflation but not with Dutch inflation. But what we are seeing now more and more is that there is very high correlation between Dutch inflation, for example, and harmonised euro inflation.”
Nick Davidson, Baring AM
According to Mr Davidson, although the market for linkers is growing significantly, it still represents only a mere fraction of the conventional bond market. “That’s one of the drawbacks because there is still a relatively small supply of linkers and to a certain extent that is what has put some people off.” He mentions liquidity and price as some of the concerns coming from investors considering investing in ILBs. “The sector has got a long way to go before it can catch with the conventional bonds market.”
Further growth will continue to be linked with demand from investors, especially those with long-term investment horizon that want to protect their portfolios against inflation.
“What is really pushing pension funds, particularly in Europe, is pension reform in response to a widespread fall in equity markets and also demographic changes,” Mr Davidson explains. “As a result, investment strategies are changing and linkers, and linkers derivatives, are now providing quite a suitable hedge for pension fund liabilities.”
A good example of how new regulatory frameworks are affecting the way pension funds look into the future can be found in the Netherlands. Here, the new financial assessment framework for pension funds, the FTK, due to be introduced in January 2006 – although recent industry lobbying may delay it further – means liability driven investment is a must. The Dutch government is now considering issuing ILBs to meet the demand from the pension industry.
Accounting reforms
“On top of the pension reforms there are also accounting reforms like FRS17 and IAS19, and managers are having to focus on assets with lower risk. Linkers are very attractive for that and also they have a very low correlation with stocks and other bonds,” Mr Davidson adds. “In terms of duration matching, if you look at Holland for instance, the duration gap between assets and liabilities is quite big. One of the ways to address this duration mismatch is by investing in linkers.”
Apart from inflation protection, investors are also interested in knowing more about the returns opportunities in the ILB market. For those in the business, the diversification of returns that can be achieved by including ILBs in an investment portfolio should continue to attract more investors to the asset class.
“There is obviously a big discussion now about whether we are going into an inflation environment or we are heading into a recession. If we are heading into a recession, then conventional bonds are likely to perform better than linkers, but in the current environment they can compete extremely well with other bonds,” he adds.
With regard to new countries issuing ILBs, the big disappointment of the year so far has been Germany that had committed to issuing between €5 to €10bn in 2005, but nothing has happened as yet. According to Helen Roberts, head of government bonds at F&C Asset Management, the fact that Germany hasn’t launched ILBs as yet may be stopping other countries such as the Netherlands and Belgium from doing likewise.
“But there are other markets that have been issuing ILBs and certainly the turnover is substantial,” she says. “In the US, the Tips (Treasury Inflation-Protected Securities) market has been growing. We don’t know whether they are going to issue very long-dated Tips there, but of course the expectation is now that having re-opened the long 30-year US nominal bond, they may also start issuing long-dated US Tips.” She comments that even though the amount of money going into long-dated bonds in general is still limited, the fact that more of these vehicles are being launched and reopened in the conventional markets, could result in other countries following what the UK has just done and issue long duration ILBs.
At Pimco Europe, portfolio manager Ivan Skobtsov, believes there is room for these type of long-dated products in institutional investors portfolios. “If you picture a typical pension fund, 50 years is actually not outside its actuarial horizon, so there could be demand for this type of products. Pension funds tend to be invested in a portfolio where assets are allocated across equities, bonds and maybe other asset classes. So maybe consultants working with pension funds might suggest that exposure to inflation-linked bonds is beneficial because it immunises their liabilities.”
Ivan Skobtsov,Pimco Europe
Mr Skobtsov argues that ILBs are not only beneficial for investors, but also for those governments issuing them, since their revenues are effectively inflation-linked.
“Also, in the UK, for instance, the government has saved tens of billions of pounds in debt servicing costs by issuing inflation-linked bonds in the early 1980s when inflation was high,” he says. “The other side of that is that investors did not make that much money, so perhaps the time to buy inflation-linked securities is when inflation is low and expectations are contained.”
Expected returns
Mr Skobtsov says investors main consideration when choosing different investment options should be risk. “By risk I mean how the expected returns would be distributed. The distribution of returns that best matches your liabilities is by definition the lowest risk. And in fact for most investors the lower risk is not the money market fund or cash in a bank account, but rather an investment that matures in five, 10 or 15 years and it is linked to inflation.”
With this in mind, investors will continue being attracted to ILBs. It is now key for the future growth of the market that countries like Germany and the Netherlands join in as new issuers. Current demand from institutions means they won’t be able to delay it for much longer.
