Both government and corporate issuers of inflation-linked bonds have had great success. Investors seem to want more and more of the product. So why aren’t more borrowers coming to market?
Inflation-linked debate Participants
MR, Total Derivatives The inflation market has grown dramatically in size and sophistication in the past few years. What have been the drivers?
AM, DMO This financial year we are issuing £17.25 billion of index-linked gilts, which is roughly as much as in the first four years of existence of the DMO put together. This is partly a reflection of the overall increase in the borrowing requirement but also an indication of the value that we attach to index-linked debt in terms of portfolio diversification, and in terms of the fiscal insurance properties it brings to government. One can also add another argument in favour of index-linked issuance, in a context of asset-liability management, which is that many government income streams are more or less indexed, and therefore having index liabilities is not unreasonable.
MR, Total Derivatives How do your two debt agencies decide where to issue on the curve?
AM, DMO Our objective is to minimize the government’s cost of funding, subject to risk. To do so, we aim at extracting a liquidity premium – which is why we issue large benchmark bonds – and a preferred habitat premium where we can. To achieve the latter, we try to assess at which part of the curve investors are willing to give up a premium to hold our bonds, and that informs our annual financing programme. We also take into account that we are a repeat issuer, so place our decisions in a long-term context. We put particular emphasis on regularity of issuance, consistency of policy over time, as well as ensuring that we maintain an efficiently functioning market structure.
AS, National Grid Why don’t you take any views on the shape of the yield curve in terms of where absolute rates are?
AM, DMO Because we do not think that we are better informed than the rest of the markets as to where growth and inflation will be in the future.
AS, National Grid There could be structural reasons, though, why the curve is in a different shape.
AM, DMO Indeed, they would result in, for instance, a negative term premium. We do form a view on that – we implicitly form a view on where we believe the term premium to be, and that affects the skew of issuance every year.
BC, AFT Our approach is very similar. Our issuance policy is constrained by the granularity of the market, that is, we are issuing large benchmarks. Now, how big is enough? The market tells you, and it has to do with the liquidity premium that Arnaud mentioned. There is an optimal size for a benchmark, and we found out that it was somewhat smaller in the inflation market than the conventional market, say, around €15 billion. So we have to commit to bring liquidity in turn to all segments of the curve and then at the margin we have to take timing decisions based on market demand. But it’s only at the margin.
AM, DMO This year we have increasingly focused issuance on benchmarks at key maturities, which means currently at 10, 20, 30 and 50-year in the index-linked curve. We have become ever more explicit on that and this has brought our issuance in the real curve more in line with the issuance policy that has been in place in the nominal curve for a while. It is, to a certain extent, a normalization of the index-linked market as it has matured.
MC, RBS Yes, initially issuers chose to issue little and often, at least relative to conventionals. But in markets such as the UK, where there has been a greater supply of inflation-linked, we should now be able to tolerate larger size of average issuance. Counter-intuitively, the fact that inflation-linked issues are a little less liquid than nominals perhaps means that the market needs a greater average outstanding issue size in inflation-linked. But having said that, redemption management is an issue. It’s not just the cashflow impact of large infrequent redemptions – it is also the issue of concentrated RPI print or HICP print risk. So maybe the governments could issue large-ish infrequent points along the curve to maintain benchmark size in inflation but use inflation swaps to disperse that inflation print risk across the curve.
OPB, Santander Well, I think the DMO structure is quite transparent. From the market-making point of view, the only question from some traders is why don’t DMOs issue more short-term linkers, to cover and trade the seasonality. This is going to be a problem for derivatives books from 2008 onwards.
BC, AFT In the eurozone both Italy and France have issued short linkers. We have an EI10, a three-year linker, which we might tap any time this year. I suspect that the answer to Oscar’s question also has to do with the lack of a futures market for inflation.
OPB, Santander Yes, none of the futures is liquid enough for the market-makers on the derivatives desk. It would be helpful to have larger issuance in the short term.
MR, Total Derivatives From the investors’ side, when you go to meetings with the debt agencies, is there a consistent plea for more long-dated gilts or more short-dated gilts?
SJ, BGI We don’t have any particular criticism of the way the DMO is handling the demand for long-dated inflation.
MC, RBS In the UK, there’s an impression from both investors and banks that the market needs maximum size and maximum duration in both conventionals and nominals. Last January was perceived as a time of high stress, and since then long-dated yields have risen somewhat. However, the distant forward nominal yields, say between 30 years and 50 years, are very close to the levels last January. So those long-dated forward rates are as stressed as they were a year ago. But in the inflation-linked side of things, that’s not true beyond 20 and 30 years, because we’ve had a lot of non-government supply of inflation in the 40 to 50 year. What is highly visible in the inflation swaps curve is forward break-even inflation rates which are very high out to 20 years, but then fall quite sharply. This suggests the market needs a lot of ultra long-dated nominals, but it’s not at all clear it needs a lot of ultra long-dated inflation. It needs more 20 to 30 year. The UK government’s liabilities are growing in duration quite aggressively year by year, and this strategy would temper that rate of growth.
MR, Total Derivatives Does the AFT take a view on the duration of its liabilities, and its linker liabilities in particular?
BC, AFT We have a view on the duration, but it’s more focused on the nominal portfolio. We have not yet found a satisfactory way to mix the inflation and duration risks, or to manage both risks in conjunction. So we focus on the duration of the conventional portfolio and have used the swap portfolio to shorten the duration to extract the term premium. We don’t have a view on the shape of the yield curve but we have a view on the structural features and on the fact that on average there should be a positive term premium. This has not been the case over the past three years, so we have suspended our swaps policy, but we stand ready to resume it if and when the term premium reappears.
SJ, BGI Maybe the term premium is not going to come back in the same way that it was. The argument for a term premium arises from the fact that most people are cash investors – people prefer money now rather than in 20 or 30 years. But in fact a lot of investors in the market are concerned with their long-dated liabilities. So if there is now a more even balance of investors that have demand across the curve, maybe a flatter curve or maybe even a downward sloping curve could become the norm.
BC, AFT I don’t think this will be the dominant factor over the next few years. Our discussion has focused on European long-term investors, but you also have to take into account that lots of overseas investors are coming to buy euro-denominated products, and rather at the short end than at the long end. The share of the euro in central bank holdings has increased, for instance. Central banks are now extending the duration of their assets, but not to that point.
MR, Total Derivatives Agence France Trésor splits supply between French and eurozone inflation. Do you see the balance between the two staying where it is, or will you migrate towards eurozone inflation?
BC, AFT I don’t think we will migrate. It’s about diversification. European inflation has virtues in terms of broadening the investor base, and maybe in terms of liquidity, because the market is bigger, and because here we have other sovereign issuers. But just in terms of our own asset liability management, it makes more sense for us and it’s probably politically more acceptable to issue French inflation rather than European inflation. It’s not very clear what would be the optimal proportion. For now, we issue broadly half of each. We have €55 billion French inflation and €48 billion European inflation outstanding. However, over the past couple of years we have seen a massive increase in the participation of non-French investors in the French inflation market. The share of non-French investors on the OAT market has risen from 32% in 2002 to 47% now.
MR, Total Derivatives And Oscar, there are a lot of potential government issuers that every year opt not to issue either in the eurozone or in domestic inflation.
OPB, Santander There is no point in issuing paper that won’t be liquid. You need support from the demand side. In the case of domestic inflation, it is important to create a whole curve in domestic inflation. I think Italy could easily issue domestic inflation, because demand is there: their retail structures are huge, and they are constantly issuing MTNs in real yields. It is not so easy for the rest of the DMOs to issue, therefore all they can do is to issue in euro inflation and get a new point on the curve. How many banks are offering inflation products without the help of the DMOs, as Santander does? It’s possible, if you get the supply, and because the demand is there. You can’t do a huge number of trades, but you can trade enough and provide these solutions to customers.
BC, AFT But I would like to state very clearly that we as a government have an interest in having entities other than ourselves paying inflation. I don’t think it’s sound for a financial market to depend too heavily on government behaviour. I think we had to give the market an initial push, but it’s even better if the market can live without us playing the leading role.
PW, Western When people read these comments, Benoît, they’re going to say that the French government is actually pulling out of the inflation-linked market! The Trésor have shown an ability to operate in both directions in the nominal market, being involved in the swap market and being prepared to sell and buy, as opposed to always be a seller, and that’s been a very strong positive. Could you see yourself being more heavily involved in inflation-linked swaps?
BC, AFT We are not going to pull out of the market and will keep issuing at least 10% of our funding requirement. We will use inflation swaps if we have a good reason to. If we find a way to manage government inflation exposure that involves using swaps, we will do it.
OPB, Santander In Spain the Spanish Tesoro, the regional governments, and in general all the big issuers need to feel real demand for inflation products, because three years ago there was almost none. Now that they see the buying side doing decent trades, big amounts, they are open and willing to go. From a bank perspective, if you have enough supply coming under bond or swap format of course you can work out solutions. In the UK both corporate activity and linkers issuance are strong. And of course it’s better to have a whole curve through linkers. But even without a linker curve it is possible to offer solutions, and an inflation market can be developed and solutions delivered based on non-DMO activity alone like any other semi-liquid market.
MR, Total Derivatives The regional governments have been issuers. Have they tended to stick to the eurozone index or the national index?
BC, AFT As far as I know there has been only one issuance by a French region on inflation, and it has been Provence Côte d’Azur, and it was on French inflation, wasn’t it?
OPB, Santander The regions can go directly to the inflation market, or do a derivative as well. As they do not issue big amounts, usual sizes being around €300 million, they have found their way through the derivatives market. We have traded inflation deals with three European regions up to now.
BC, AFT Remember we come from a very strong anti-indexation culture, for good reason. We had to enforce a disinflation throughout continental Europe. And we’re only gradually moving out of this environment. We lifted this ban on indexed loans only two years ago, and we are beginning to see some housing loans being indexed on inflation. But the regions, for instance, tend to use more loans than bonds. So again, we are only at the beginning of the maturation process.
Corporate issuance
MR, Total Derivatives Let’s move on to corporate issuance. In the UK we’ve seen a big growth in supply, but not in continental Europe. Philippe, could you talk us through the reasoning for your issue and why you think that others haven’t followed your lead?
PM, Veolia The first reason why Veolia issued was because of the link between our revenues and inflation, and that was also why we decided to go to the primary market rather than the derivative market, for instance. If a corporate decides to use derivatives to hedge part of its exposure, you have to be able to show that there is a pure link between your exposure and the instrument used. Also, given the calculation of the debt and because of the coefficient inflation calculated during the life of the bond, you’ve got a duration that is higher with a linker than with a plain vanilla bond. The last reason was to enlarge our investor base. Also, legislation has been a problem in France because until the end of 2006 the insurance companies were not allowed to buy some linkers issued by corporates because of mark-to-market rules. That has changed now, which could enlarge this investor base dramatically.
BC, AFT There has been an interesting evolution recently. Increasingly inflation is being sourced through a structure, PFI or other project finance, meaning that it’s channelled directly through the swap market or through more structured derivatives, rather than through the bond market. As a bond issuer I don’t mind, because I think that there is an interaction between the two markets. It’s a good underpinning for the bond market to have a well-functioning derivatives market. Increasingly we see the inflation market move closer to the conventional market, for instance, in terms of pricing mechanisms. The inflation swap curve plays a much more important role than a few years ago. That’s a normalization process. It’s a maturing market and it’s perfectly okay if inflation is sourced through the swaps rather than through the bonds because at the end of the day, banks have to shed their inflation exposure and buy our bonds.
MC, RBS One of my great hopes on the corporate issuance side is that perhaps the reason why inflation-linked issuance hasn’t taken off yet to a great extent in the euro area is partly because we were in a low short-rate environment, but that has changed now. Corporate Europe moved into very much a Libor financing mentality as carry savings drove financing shorter on the curve. Now we have an environment where ECB rates are heading towards a neutral rate, which many perceive to be 4%, and if inflation hits its target of sub 2%, then the carry game has changed completely. The relative cost of capital calculations – floating versus nominal, nominal versus inflation-linked – all changes, and that should be a catalyst for real rate financing. That’s been a key to the boom in the UK.
MR, Total Derivatives Alison, is that something that’s pushed you to market?
AS, National Grid Yes, we’ve been driven by the low real rates, which are also driven by structural demand changes. But there are other reasons. Regulation is one. Our revenues are inflation-linked, so it’s a good match for us in our operating companies. And a fairly new development for us has been the emergence of the insurance wrap market. In the UK there are more names than in the euro market for credit inflation issuers but National Grid and all our subsidiaries account for a reasonable proportion of the credit market, so demand for our name is limited. But insurers have wrapped our issues, and some banks have arranged the wraps and then sold triple-A rated paper on to the end investor. That’s enabled us to achieve better pricing.
MR, Total Derivatives Would you call it opportunistic, in that you mentioned the real yield there was obviously attractive for you, and the combination of the wraps and the negative basis has helped make issuance attractive for you? So when these stars aren’t aligned, will you then not go to the linker market or do you see that continuing?
AS, National Grid We’d like to do more in the linker market but the wrap capacity is finite, so when that’s all utilized we’ll have to assess the relative value. We may not want to pay up to 10 basis points more through not having a wrap, and we may decide then that other structures will be better for us. We like to match assets and liabilities but not at any cost.
MR, Total Derivatives Is there more the banks can do to make the product attractive?
MC, RBS Arguing the case for borrowers to use inflation-linked finance has increased in profile across the bank. We can now source domestic inflation in lots of these economies – Scandinavia is a region we have had notable success in recently, for instance. Property companies see a natural hedge with their assets and inflation, so they are often very comfortable with taking on a domestic inflation-linked liability against a property asset. And as the investment banking industry grows in this product, its risk appetite has grown. There is a willingness to break down euro area inflation into its component country parts and sell the "pieces" to different domestic markets.
PW, Western Clearly a lot of the structured product issued in Europe actually has embedded floors, and somebody is underwriting those floors. Philippe, do you look at the value that you might get from tagging on a floor or a more exotic element to your issuance?
PM, Veolia No, not at the moment. About 66% of our revenue is made in euro land, so we decided to issue on the euro linker. After that, of course, you can fine-tune your position and swap from European index to French index, for instance, but it’s a very basic position.
AS, National Grid We have got some LPI issues, but it’s quite a small proportion of what we’ve done. We’re trying to match our asset flows and we don’t have an explicit floor at zero percent. It’s never been tested, but presumably our revenues would start to go negative if inflation went below zero. So we see straight RPI as the best match, although we wouldn’t rule out ever doing LPI again.
PW, Western Some companies should be clearly issuing inflation-linked bonds, even if they don’t necessarily have inflation-linked revenues. Whereas companies that have a very big defined benefit scheme sitting on the borderline of the balance sheet without inflation-linked liability are actually already short inflation-linked bonds and probably shouldn’t be issuing them. And more sophisticated companies that don’t necessarily have a pension problem, say with a very young labour force, should be prepared to let some of its balance sheet go over to a company that really is desperate to defease one of its biggest risks.
OPB, Santander But getting corporates into the non-UK market is more difficult. The UK market is very clear with regards to indexation, the supply from corporates is constant and the legal framework is very stable. That’s not the case in continental Europe. We find it very difficult to convince utility companies or transport or highways to hedge inflation, because they don’t have a clear idea about future tariff indexation. In addition, every country is different. Often, supply generates its own demand. In European inflation, corporate supply side is limited, and the demand from the continental European pension funds is not as strong as in the UK either. We are still waiting for new regulations to be implemented and hedge rates to be studied.
Investor demand
PW, Western So there are clear benefits to issuers. But what has really driven the market is demand. People recognize that they either have direct, explicit or implicit linkages somewhere in their liabilities to inflation and they need fairly accurate matching or hedging instruments. You must have seen that, Stuart?
SJ, BGI We’ve certainly seen increased demand for liability driven investments (LDI) and have invested heavily to meet it. I would say that the driver is the change in the way that pension schemes think about their liabilities. That’s fundamentally a change both in the way that actuaries value and understand those liabilities, and also the way that shareholders understand them. We’ve seen a big change in the accounting regulations: FRS17 had a great impact six or seven years ago in the UK, and that impact is still being felt. You’ve seen much greater understanding at the company board level about what pension scheme liabilities mean in terms of the interest rate and inflation risks they’re running. At BGI we think of LDI as a holistic strategy: it’s not just about looking at hedging the interest rate and inflation risks, but also covers investors thinking more widely about what risks they want to take within a pension plan and more widely within a corporate balance sheet.
The other great change is that corporates and investment banks have got much more innovative over the past couple of years about sourcing inflation, and bringing the supply to the market. The bulk of pension scheme inflation-linked liability in the UK is linked to inflation up to a 5% cap, and through late 2004/early 2005 the banking sector was able to source that kind of inflation in the corporate market. This was then supplied in swap format to pension schemes – schemes like swaps because they’re very capital efficient. But then we saw a decline in yields over the course of 2005 to the point where, at the long end of the curve, there was almost no difference between the rate of the real yield you’d get in the physical bond market compared with the swap market. But over the course of 2006 we saw a massive increase in that swap spread. You’re now seeing more reasonable levels, which indicate a much healthier balance between the supply that the banks are bringing into the swap market compared with the demand that we’re seeing from pension schemes. Terms for inflation which can be used to hedge liabilities are much more attractive now than they have been really since LDI kicked off in a big way.
OPB, Santander I agree that the driver right now is risk management. You see this in PFI activity, where the leverage has been increased massively in the last two, three years. Financial lenders request to hedge the long-term flows in every PFI when it’s possible. For the institutional investors, the global market, as you said, the fact that the inflation is at a low level has not diminished the appetite for hedging. In such countries as Ireland, Spain or potentially Portugal or Italy, the demand for real yield product is strong. We believe that all this demand will remain in the medium term.
MR, Total Derivatives And the pension demand that is coming through is presumably from Germany and from the Netherlands?
OPB, Santander Yes, there is demand coming from Germany, the Netherlands and France but other domestic markets such as Spain have an important need for hedging as well. Institutional investors prefer to go to liquid markets like the UK, France or Europe, but the pension funds and insurance companies are looking for domestic inflation. On the supply side, it’s difficult to get corporates to think about paying inflation because of this lack of legal stability. We need some kind of harmonization in the regulatory framework to reach a UK-like market .
MR, Total Derivatives And do you see that changing in the future?
OPB, Santander We are working on it. With all the PFI we are involved in and all the corporates we are visiting and trying to convince that hedging inflation is a good opportunity, eventually we will see more people getting hedging inflation as a common practice. We are very positive but it’ll take at least between three and five years.
Role of hedge funds
MR, Total Derivatives What about hedge funds? Are there opportunities to add alpha and add value for the pension fund?
SJ, BGI In terms of generating return, pension schemes are taking a view on the shape of the yield curve, thinking about where value can be obtained. That’s an active view. They expect to get rewarded for that over maybe a reasonably short period as the yield curve reverts to, in quotes, a "normal" shape. There are plenty of opportunities.
The other side of this risk management coin is diversification. That single view – on the direction of rates – is too dominant in many pension schemes at the moment, and it is preferable to spread the risk budget across a multiplicity of views. Hedge funds and active management of individual pieces of portfolio then have a key role to play.
BC, AFT I agree that hedge funds can play a useful role in some instances but the market should not be organized around them. We’ve seen that for instance in our conventional market when we issued OAT 2055. We allowed a substantial share of hedge funds in the order book, because we felt at the time that our interests were aligned. We felt that demand would develop at the very long end of the curve, that it would take some time and that it was okay if those actors wanted to pile up 50-year bonds just until the 30-, 50-year spread becomes sufficiently negative. Something comparable took place in the inflation market some years ago when there was a significant spread between French and European inflation. We saw significant non-eurozone investors taking positions rather aggressively on French inflation, playing the convergence. They were just spreading the price impact of some event over time, and that was okay. But we don’t want the market to be organized around them. We want the primary dealers to perform the role of market-makers in the inflation market as in other market segments.
MC, RBS I think that the presence of hedge funds has been a critical benefit to the development of several inflation-linked markets. In the very early stages of a linker market you have a hard core of evangelists who say, ‘this is a wonderful product, it’s great for borrower and investor, and we’ve got to have it’. They are the early adopters, who help the first few auctions. Then there’s the mass real money investor base that hasn’t seen these things on the radar and hasn’t been dragged up the learning curve. So linkers can then start to trade quite cheaply for a while, encouraging mass acceptance. But in that intervening period where the market trades cheaply, that’s when the hedge funds come in, furnishing liquidity. They were very active in the early years of the TIPs market. Hedge funds were also important in the early days of the UK 2055 bond, when the bond traded very cheaply on an asset swap basis.
AM, DMO For the market to function efficiently, there has to be a sufficient number of participants willing to commit capital to it. The more participants are willing to warehouse risk, and the more different participants with different views in the market, the more liquid the market will be. Good liquidity, and low bid-ask spreads make it in turn easier for relative value traders to enter the market, and they add themselves to liquidity. So liquidity breeds liquidity. If, on the other hand, fewer participants are willing to commit capital to the market, its risk absorption capacity will be reduced, spreads are likely to widen, relative value traders may desert the market and liquidity will suffer. A diversified basis of investors and other participants able and willing to commit capital is therefore to be welcomed.
OPB, Santander We all agree the hedge funds are very important because the inflation market is not the most liquid one and they provide liquidity. And it is true that the intra-day movements have been significantly reduced, even during last year’s turbulence, because the hedge funds are constantly playing the relative value. In France we see all the distortions coming from the ALM smoothed by hedge funds activity. But we are now at the point where market makers or banks can support the market, and hedge funds are becoming more and more aggressive in volumes.
PW, Western The market is certainly a long way down the road of development. But because most of their activity takes place in the swaps market these days, hedge funds still iron out the kinks on the curve, which is useful. At the beginning we relied upon them to normalize relative value between nominal and linker markets and that we don’t need so much these days.
MR, Total Derivatives Do the corporate issuers mind which investors take their debt, or is it that if the right bank comes along with the right price then you’ll do it?
AS, National Grid I suppose we’ve always had a natural preference to place our paper with an end investor who’s going to hold of it and we don’t want to see our paper trading wide. But the index-linked we’ve done within the last year has been pretty much on a private placement basis. The negative basis trades have gone to banks, but I don’t think that hedge funds have been particularly active in buying the corporate paper.
PM, Veolia I share Alison’s view. Generally speaking, we don’t like hedge funds on bond issues, because if there are so many it’s not good for the group, and especially for the linker. Before issuing something we have to look at where the investors are, where the market is in terms of duration, in terms of size, to make sure that we’ll be successful.
Liability-driven investment
MR, Total Derivatives Have we seen the growth that people are talking about in terms of LDI? And do we see this continuing in terms of pension funds using LDI?
SJ, BGI Risk management is here to stay. An increasing number of pension schemes are taking risk much more seriously than they did four or five years ago, both hedging risk and spreading risk. There are always these twin themes of hedging some of the interest rate risk which is met in the liabilities but also diversifying risk across multiple asset classes. Inflation has a role there, on both sides.
PW, Western Clearly, there’s hedging inflation-linked liabilities, as in UK or Dutch pension schemes. Also the idea that you can generate some return potentially with global inflation, and that has a role in the return-seeking part. Corporates and pension schemes are both de-risking and thinking much more carefully about where they take risk. The number of pension schemes looking to put in place more robust policies will definitely increase over the next three or four years.
MR, Total Derivatives We’ve seen a couple of funds use other solutions to get inflation, not through the swap market, not through the gilt market.
SJ, BGI Yes, directly using PFI deals for example. We’ve had companies that have siphoned off bits of earnings from maybe a property or maybe a particular piece of their business into the pension scheme. It works quite well as a way of cutting out the middleman, the market. They’ve got these two things happening on the asset side of their balance sheet and the liability side of the balance sheet, so they try to bring those together in a clever way, which makes sense for their business and makes money for their shareholders. It’s all part of this whole risk management ethic, which is taking hold in corporate UK. I would say that’s an unusual way for many companies to behave at the moment, and it’s an unusual company that has that kind of earnings stream on its balance sheet that it can use for the pension scheme.
PFI issuance
MR, Total Derivatives Obviously PFI and infrastructure supply of inflation is a big part of the UK market and it sounds as though it’s growing in Europe as well. How does everyone view PFI issuance? Is PFI supply providing what the pension funds and what the investors want? Are the banks structuring it in a form that they want?
SJ, BGI To the extent that it’s supporting the market, and creating supply, it’s a great boon. Around this time last year, we saw real yields crash, and one reason was that people suddenly got scared about a few PFI transactions. But the market kept going, yields recovered and pension funds were again able to carry on hedging some of their liability risks.
MR, Total Derivatives In the UK at least, it takes a lot of government intervention before the deals finally get approved. Is there a risk premium there?
PW, Western I think it’s fair to say that last year’s disappointment over a number of PFI deals has been well flagged and therefore well mentally digested by the market. But I believe that post-January circumstances have improved the situation, because clearly now the DMO can step in with emergency financing. I suspect the market will be able to deal with delays and cancellations much better now with the current framework of potential emergency financing.
AM, DMO Last year many concerns were expressed in the market regarding the unpredictability and lumpiness of demand, as well as that of non-government supply. There are two things we could do to help in this respect: first, avoid adding to uncertainty by ensuring the transparency and predictability of government supply and, second, increasing the frequency and regularity of index-linked issuance, in this way ensuring that anybody in the market who seeks inflation exposure has an opportunity to access it through our auctions within a relatively short amount of time. Which is why this financial year we have committed to monthly issuance at the long end of the real curve. Of course, that frequency was possible given the relatively large quantum of index-linked issuance this year, but might not be possible every year, especially when we have less to issue.
MR, Total Derivatives What are the markets like in France and Spain, for this kind of non-government supply?
OPB, Santander PFI is a driver of the UK inflation market but that’s not the case in Europe. We do PFIs and we hedge positions on inflation but it’s not as transparent and predictable as in the UK market.
PW, Western But I think Spain is probably the one area where PFI infrastructure really has been a pretty significant development.
OPB, Santander Yes, as you know, Spanish real estate and Spanish building companies are very well placed on the PFI rankings in the UK and all over Europe. They are willing to hedge inflation exposure but they don’t know to what extent they should hedge, because the contracts and the legal framework are not always clear with regards to indexation.
MR, Total Derivatives Obviously RBS has been a big player on the PFI side in the UK. What’s your view of the way that the supply comes to the market through the PFI route?
MC, RBS Inevitably these transactions are often very complicated and there can be delays but that’s true of both the supply and the demand sides. A key thing will be the continuity of PFI through any possible change of government.
MR, Total Derivatives Do you investors buy PFI deals or not?
PW, Western Certainly on the active management side we do. But I think Alison’s point about being full up on a name is the primary issue, and now we’re getting a bit full up on the monoline wrappers too. So we do need more issuers in the marketplace. Philippe, do these non-government guys crowd you out?
PM, Veolia No, I think the key point is the liquidity you can offer to the market. We are involved in some PFI – but a very small amount. So it would be difficult to come to the market and issue a linker in this case.
Future challenges
PW, Western So, finally, what do the banks need to do to keep this market developing and growing?
OPB, Santander Well, having developed a liquid market our next step is to offer more domestic indices and more exotic solutions. Today the market is fairly liquid, and enables taking and releasing basis risk. Traders can source German inflation, Belgian inflation, Spanish or Italian inflation in the inter-bank market. Now that business in the core market is getting squeezed by the reduction of the bid-offers, the market is offering domestic or exotic tailor-made hedges where corporates and customers are happy to pay more in order to be perfectly hedged.
MC, RBS The challenge for investment banks now is to convince corporate sectors globally that earnings per share are strongly correlated with inflation, and that therefore inflation-linked liabilities are natural liabilities, not just for utilities or for certain types of infrastructured project finance. It’s about the entirety of the corporate sector.
Role of inflation in issuance/demand
MR, Total Derivatives It’s interesting that no-one has mentioned the actual level of inflation, or inflation expectations, as major influences on market development.
MC, RBS Italy and Spain have seen strong demand for inflation structures, typically short dated. Perhaps the reason they’ve been so popular there is that they have a history of higher inflation so they value inflation protection more.
PW, Western Sometimes you just have to have some real inflation protection for a rainy day. Because of the developing world, globalization plus the behaviour of central banks, we’re all encouraged to believe that inflation is going to remain very low and under control, even though we have regular shocks. And we are moving into a world where regulation requires us to be better matched. In the past we were probably not paying as much attention to our liabilities and just looking for total returns. High equity returns indulge this. Now we’re at the other extreme thinking about liabilities, possibly even too much.
SJ, BGI The issue of whether the current market levels are fair comes up a lot in LDI-style conversations. Where pension schemes are thinking about whether they should be hedging, the discussion is normally framed in terms of the level of the real yield, rather than the level of a break-even inflation.
The impact of a low level of yield is to keep demand away from the markets. It drives a lot of pension schemes away from the idea of hedging right away. Price is the natural market mechanism but there’s still a wall of pension liabilities there waiting to hedge, waiting to get to the point where they are better funded. The level of the real yield stops them from doing that immediately, so that overall the market is behaving in a relatively orderly way.
Is there too much focus on liabilities? I would say it’s sensible risk management. A lot of pension schemes sit down like adults and think about what risks they want and don’t want to take. I haven’t got any clients who are hedging all their interest rate inflation risk off their balance sheet, but most feel they’ll get a better return for that risk budget by spending it in these other markets, and by diversifying those risks elsewhere.
BC, AFT The perception of inflation depends very much on the horizon. The textbook definition of stable inflation is where nobody cares about it, and currently we are living in a period of very low inflation. But of course when inflation is accumulated over 30 years, the risk is magnified by duration. People also remember the past errors of higher inflation, and that’s important. The consequences in terms of market organization are that short-term and long-term inflation are very different market segments: short-term inflation is very much a trading product, an arbitrage product, a diversification product, and long-term inflation is very much an LDI product. This may also have consequences in terms of valuing the inflation curve. If we follow this line of reasoning, the inflation premium should be higher at the long end of the curve than at the short end and break-evens should be steeper. Inflation should be more expensive long term than short term.
MC, RBS I was surprised when I looked back at the actual index ratio performance for the first of France’s euro inflation issues. The index ratio is 1.105. That means that, since the bond was issued, there has been indexation averaging 1.8% at an annual rate over 5.5 years. Now, over the life of the market, break-even inflation rates have been consistently above 2%, apart from the very early patch. In that sense inflation rate expectations have remained above what has been delivered. We have a situation now where the term structure in the nominal curve is very flat but the term structure of the inflation curve is quite steep. So there’s a fierce inversion at the long end of the euro area real curve. There’s a paradox where you have a term premium disappearance from the nominal curve but a significant inflation risk premium remaining in the break-even inflation curve, and I would have thought that they are close cousins. That suggests an acute demand for long-dated inflation-linked protection in the euro area, and I suspect a lot of it is from the Dutch pension funds.
PW, Western I think the capacity of investment banks to come up with something sexy and new on a regular basis shouldn’t be underestimated, But inflation structured issues have been dampened by the outright fall in European inflation. These structures have been particularly popular in Italy and Spain because of their historical inflation issues. But Italian inflation has rolled over and there are signs that Spanish inflation is starting to roll over quite quickly as well. Although it’s 12% of the eurozone inflation index, Spain contributed 100% of the inflation ceiling overshoot in 2006. So Spanish inflation is coming back from a pretty high level, because Spain has lost economic competitiveness. Those may be issues. We’ve talked about trades that hedge funds do, such as forward French versus forward euro. Building those into notes has been popular, multiples of inflation and so on. In the UK people will start to look at more real curve CMS trades. There’s been a huge focus on current inflation-type structures, but I think we need to look at real rate structures, real curve structures, with a fiercely inverted real curve at the front. I also think the straightforward bullish inflation structure may be on the wane for now.
