| Index-linked bond 101 |
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| 18/12/2005 | |
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Laurent Gonon, index-linked bond manager at Axa Investment Managers, answers this week's 101 on index-linked bonds. 1 – What are the index-linked bonds currently available on the European and American markets? Are there any significant differences between them? The UK was the first country to issue inflation-linked bonds in 1981. Then the US followed in 1997, and finally the Euro in 1998. The nominal of these bonds is indexed to inflation, which means that both the value of the bonds and the coupons of the bonds are protected against inflation. Euro and US inflation-linked bonds have adopted the same format, that is, the "Canadian model", from the format of Canadian inflation-linked bonds issued for the first time in 1991. In the Canadian model, the indexation has a 2-month lag for technical reasons: for instance, March inflation will only be released in mid-April and then impact the index in May at the earliest. UK linkers have predetermined semi-annual coupons, which means that their indexation has an 8-month lag. At maturity, US and Euro inflation-linked bonds have a minimum redemption at 100% even if inflation was negative enough to push the index below 100%. The UK inflation index is the RPI (retail price index), the American index is the CPI-U index (consumer price index for all urban consumers) and in the Eurozone, there are two indexes – both ex-tobacco, a French and a European. Furthermore, as for conventional bonds, UK and US inflation linked bonds have a semi-annual coupon, whereas Euro inflation-linked bonds have an annual coupon. In the US, the US Treasury is the sole issuer. Its issuance policy has evolved during recent years and it now issues 4 inflation-linked bonds per year: one 5-year, two 10-year and one 20-year. In the Eurozone, there are many more issuers: France, Greece, Italy, and some non-government issuers like Cades, RFF or Veolia. The UK is probably the most developed country in terms of variety of issuers: besides the UK Treasury, there are a significant number of corporates like utilities (Thames Water, Scottish Power) or retail stores (Tesco). Many of the issues are wrapped (AAA raised). These three markets account for 90% of the world inflation-linked bonds market: the US amounts for $ 350bn, the European for $ 185bn and the UK for $ 192bn. 2 – Should all long-term investors have index-linked bonds in their portfolios? What is the impact of those bonds on a portfolio containing both equities and bonds? Investors who have inflation-linked liabilities should obviously have inflation-linked bonds in their portfolios since this asset currently offers the best hedge against inflation. Inflation liabilities can be explicitly written in contracts, or more implicitly as a commitment investors may have with their clients (a commitment to revalue the pension according to inflation, for example). Other investors should also be aware of the fact that inflation can significantly erase the value of their investments. In this regard, inflation-linked bonds are truly risk-free assets that protect the purchasing power of the portfolio. In theory, one should start building a diversified portfolio with 100% inflation-linked bonds and then add risk with other asset classes (bonds, equities, real estate…). In the end, a diversified portfolio containing equities and bonds can easily hold between 20% and 30% of inflation-linked bonds. Adding inflation-linked bonds to a bonds/equities portfolio will reduce the risk of the portfolio. As a consequence, the addition of inflation-linked bonds will enable the portfolio to hold more equities while maintaining the same level of risk. In these conditions, the expected return will be improved. 3 - Is there a way to replicate the effect of index-linked bonds in a portfolio without directly investing in linkers, e.g. by combining other assets and derivatives together? Many investors used to hedge their inflation exposure by combining equity and/or real estate positions. In recent years, this strategy proved to be too volatile and not close enough to the target, even if it may be efficient over a very long-term horizon. This is why these investors looked at inflation-linked products. But some of them cannot move their portfolio easily and rapidly, partly due to accounting regulations. One solution is to be found in inflation swaps used as an overlay of the portfolio. Combining bonds with inflation swaps will replicate the effect of linkers. Other investors may be interested by the combination of bonds and inflation swaps. That's the case of investors who need to match a specific maturity with inflation protection since linkers do not cover the whole curve, especially on long maturities. Investors looking for a credit inflation-linked portfolio face the same problem, as there are nearly no corporate issues in the inflation-linked market. The same result would be obtained by investing directly in linkers with an overlay of CDS (itraxx for example). |
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Articles of the same Serie : 101 |
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