Packaging Inflation-Linked Bonds

Includes: IPE, TIP, WIP
by: James Picerno

Inflation respects no political border, which means that targeting inflation-linked bonds on a global basis is a natural for investing strategy. It’s also timely. Pricing pressures are bubbling in economies around the world. Consumer prices in OECD countries (a proxy for the developed world) rose by 3.5 percent in the year through this past January—the highest pace since 2001. Inflation is also on the rise in emerging markets, including China, which reported an 8.7 percent jump in consumer prices for the year through February—up sharply from 2.7 percent for the same period a year earlier.

No wonder that the global market for inflation-linked bonds is bubbling as well. Growing demand for hedging inflation is one reason. But there’s the portfolio-diversification angle, too. Investors increasingly see inflationprotected obligations as a distinct asset class, even when compared with conventional bonds.

As it happens, the supply of so-called linkers is rising, too. More governments than ever are issuing inflation-linked bonds. The global market capitalization for sovereign inflation-linked bonds jumped 50 percent to $1.5 trillion in the two years through early 2008, according to Barclays Capital.

The U.S. remains the biggest issuer, which translates into roughly one-third of global market cap. That means that most of the world’s linkers are floated offshore on a value-weighted basis. It may surprise the casual observer to learn that Brazil is ranked fourth in market cap for inflation-linked bonds. According to a new global linkers bond index from Barclays, 19 governments (including the U.S.) are now issuing securities in this corner of the debt world.

In another sign that this sector of the bond market is coming of age, the first ETF targeting the asset class has been launched. State Street Global Advisors rolled out the first international inflation-protected bond ETF in March: SPDR DB International Government Inflation-Protected Bond ETF (NYSEARCA:WIP), which tracks the DB Global Government ex-US Inflation-Linked Bond Capped Index, a benchmark of bonds from 18 developed and emerging countries save for the U.S.

More global inflation-linked products may be coming, including some based on the new Barclays Capital Universal Government Inflation-Linked Bond Index. So says Ralph Segreti, the London-based global inflation-linked product manager for Barclays, which has been a leader in trading and analyzing linkers. In a recent interview with Wealth Manager, Segreti discusses the firm’s new benchmark, how it works and why investors should consider inflation-linked bonds as something more than a domestic asset class.

Q: What’s the rationale for the new Barclays Capital Universal Government Inflation-Linked Bond Index?

A: This index allows you to get a truly diversified global allocation and effectively buy the global real yield. It’s comprised of inflation-linked bonds issued by sovereign debt issuers from a variety of countries. So it’s a bond market index, not an inflation index. It reflects price movements on the bonds and the underlying real yield movements, as well as the inflation compensation that’s paid.

The thought process behind the inflation index’s creation is one of providing a new tool for investors as they look to globalize their portfolios, increase diversification and search for higher real yields.

In the 1990s, we started publishing inflation-linked bond indices covering the main investment-grade sovereign issuers. In the last couple of years, we’ve noticed a large increase in our business in emerging market inflation. [The growth has come] mainly from developed-market inflation investors looking for alpha opportunities, a more diversified global basket, higher real yields, greater exposure to things like food price inflation and so on. Last year we created the emerging market inflation-linked indices. Then, after consultation with investors, we decided that what the market needed was a truly global, universal index. Our new index provides the ability to invest in a globally diversified portfolio of inflation-linked bonds, which hopefully captures improved performance and diversification benefits.

If you believe that the inflation pressures we’re seeing are a global phenomenon, global allocations make sense. Indeed, real yields recently have been considerably higher in a number of other geographies [relative to the U.S.].

Q: Nominal yields certainly vary in markets around the world. Do real yields differ on a global basis as well?

A: They’re not similar, and there isn’t a global real yield. The markets haven’t converged in that sense. So, there’s a divergence [in real yields], which creates relative value and alpha opportunities, and that’s one reason why people are looking for global portfolios.

Q: Is it fair to say that another reason that real yields vary is because monetary policies and economic cycles differ from country to country, and the divergence is reflected in a range of real yields?

A: Exactly. For example, in the U.S. people are worried about the possibility of recession and an incredibly accommodative Federal Reserve, while in Europe, the ECB isn’t as accommodative.

Q: What countries does your index cover?

A: It encompasses the developed countries—all the G7 countries are in there, as well as a few others like Sweden and Australia, along with emerging markets. Overall, our universal index reflects a diversified global basket of inflation-linked bonds.

Q: What is the weighting strategy for the index?

A: It’s market capitalization weighted. Market cap here means the outstanding amount of total market value. If you have a bond issued at par, and it’s trading at 110 with a billion dollars of the bond trading, market cap is $1.1 billion. So market performance definitely figures into the calculation. Overall, the index’s total market capitalization is about $1.5 trillion.

Q: Who are the leading sovereign issuers of inflation-linked bonds in the world?

A: The U.S. is the largest issuer with a roughly one-third weighting in the index. The U.K. is second with about 20 percent; France is third at about 14 percent, followed by Brazil at around 9 percent. It trails off to Italy, Japan, Canada, Sweden, Germany, Argentina and on down.

We also have versions [of the index] that cap the U.S. at 25 percent. In fact, we can customize the index any which way. For example, some investors might want an ex-U.S. version if they already have TIPS. We can slice and dice as you want.

Q: How does your new index compare to global inflation proper?

A: It depends on how you measure global inflation. For instance, many people are concerned about the BRICs—Brazil, Russia, India and China. The only BRIC representative in the index is Brazil, and it has a reasonably high weighting. If you look at Asia, which a lot of people target, you have Japan, Australia and South Korea [inflation linkers]. But you’re not getting a full and complete picture [of inflation with the index]. Instead, you’re getting a complete picture of the marketable securities that are available from the governments that have chosen to issue inflation-linked bonds.

Q: How might the index change if more countries start issuing inflation-linked bonds?

A: Our indices are designed so that if India, Russia and China come on board and start issuing inflation- linked debt, they easily will fall into the index. It’s a rules-based index, so it’s likely that [new bonds from those countries will] \drop in once you get sufficient size issuance. There were press reports a few years ago of India looking [at the inflation-linked bond market]. Russia said it’s probably not going to do anything for a few years. But over time we’d like to see the larger global economies all issue inflation-linked bonds, and when that happens, they’ll be added to the index.

Q: It’s clear why investors buy inflation-linked bonds—hedging against higher inflation, for instance. What is a government’s motivation for issuing inflation-linked bonds?

A: There are several incentives. First, it broadens the investor base and lowers your overall cost of debt financing. When you issue inflation linked bonds, you draw in more international capital. It also lends more credibility to your monetary policy because it sends a signal to the broader world that you’re serious about containing inflation. If you’re issuing inflation-linked debt, it’s more difficult to inflate your way out of problems, and so issuing the bonds lends credence to your monetary policy aims. It also allows for better monetary policy decision-making because it generates market-based expectations of future inflation. People are actually putting money down on inflation expectations [when they buy inflation-linked bonds]. And that’s believed to be more reliable than just surveys or forecasts [for predicting inflation]. The Federal Reserve and the European Central Bank use inflation-linked bond markets for expectations of future inflation, which then gets channeled into the monetary policy decision-making process.

Q: An ETF has already been launched on a competing global inflation- linked bond index. Will the Barclays index also become the basis for creating securities?

A: Yes. This, too, is an index that can be used for creating mutual funds, ETFs and other products benchmarked to it. We’re going to bring out products and distribute them via our institutional sales force as well as through the private bank channels to high-net-worth individuals. We’re also talking to asset managers, ETF managers—we’re looking for things like mutual funds and other products that will make the index more broadly available.

Q: Is there a Barclays iShares ETF linked to your inflation-linked bond index on the horizon?

A: That’s [a decision for] Barclays Global Investors. Although we have the same owner, that’s not us [Barclays Capital]. I will say that ETF products are proving quite attractive and successful, and I’d like see ETFs and mutual funds launched based on the index at some point.