AFT reflects on a new asset class

Benoît Cœuré

Even in a period of low inflation, new types of investors are coming to this asset class with every issue. The level of demand has prompted Japan, a country that famously has no inflation, to join the rush to issue linkers.

But in 1998, when France's state funding body, Agence France Trésor (AFT), became the first institution to issue euro-denominated inflation-linked bonds, it felt it was taking something of a leap into the unknown.

Benoît Cœuré, deputy chief executive at Agence France Trésor (pictured above), explains. "It may seem easy now but it was not an easy decision to make – it was not easy to guess," he says. "Pricing an inflation-linked bond requires a notion of inflation over the long term."

Luckily, that is the sort of challenge that Cœuré relishes, being an economist and civil servant by training. It may not be everyone's idea of fun, but his eyes light up when he talks about combining the intellectual rigour of predicting inflation rates with the practicalities of structuring bonds.

That first euro-denominated French linker from 1998 carried a 10-year maturity, and the following year, in an effort to start to build a curve, a similar 30-year bond was launched.

But when AFT decided it wanted to issue based on two different inflation indices – one French and one eurozone-wide – some of the banks disagreed with the plan. "Some of the primary dealers advised us to use just one," says Cœuré. "But we decided not to because we thought demand would develop in both, and we were proven right."

AFT has now issued French linkers with a range of maturities from 10 to 30 years, with a eurozone curve covering 10 years and, more recently, 15. Greece joined the market in 2003, issuing a 22-year eurozone inflation-linked bond, and Italy's similar five-year offering, also from 2003, demonstrated how important the asset class is now becoming to European sovereign issuers.

AFT's decision to pay both French and eurozone inflation opens the opportunity for investors, particularly hedge funds, to arbitrage between different bonds and create proxies for European inflation in countries that have not yet issued linkers, such as Germany, Spain and the Netherlands.

This kind of interest from hedge funds and the relatively high levels of placement that the linker bonds find with those investors has come as a surprise to Cœuré. For the 2012 and 2032 OATei (eurozone inflation-linked) bonds, hedge funds formed 15% and 10% of the investor base respectively.

"We thought it would be a buy-and-hold instrument," says Cœuré. "We thought most investors would be long-term investors with an intrinsic interest in hedging inflation risk such as pension funds. In fact they play an important but not a dominant role. We have seen lots of unexpected actors such as hedge funds." Insurance and pension funds do account for over 20% of placements, but this is lower than the nature of the instruments would suggest. Primary dealers have been keen to take AFT on roadshows even in Asia, not necessarily to promote individual issues but to build long-term relationships with a wide range of investors.

January 2004 marked a new stage in the maturity of linkers as an asset class when AFT launched the first of its new regular auctions. On the third Thursday of every month apart from December and August – the month of the famous French grandes vacances – AFT will auction linkers. "Before 2004 we had the option to auction in conjunction with any of our other regular issues and we gave no indication of possible auction dates," says Cœuré. "That gave us a lot of flexibility. Now the market is more mature and it is possible to bring the standards of issuance closer to that of normal debt."

The scene in AFT's office, which is located in the ministry of finance, on the day of the first of those regular auctions, was curious. While the primary dealer syndicate desks were no doubt buzzing with phone calls, Cœuré and his colleagues were perfectly calm. From the e3.6 billion bid, just under e1.8 billion was auctioned, with the largest pocket of demand for the OATei 2032, followed by the 2012 and the 2020. "Every time we issue it helps to uncover new pockets of demand. Supply is creating demand," says Cœuré.

Even on auction days, Cœuré and his colleagues can afford to be relaxed, because the past performance of new issues and taps has been positive. And the surge in liquidity in these bonds since the introduction of eurozone inflation-linked issues provides an extra layer of comfort. Primary dealers have reported an increase in monthly trading volumes for these kinds of instruments from e2 billion to e15 billion over that period.

AFT is now committed to issuing at least 10% of its bonds in the form of linkers. That means issuance this year will reach at least e12 billion. "We have set that floor of 10% because we want to give a guarantee of liquidity," Cœuré explains. "The proportion is certainly increasing because demand is strong. We will adapt to demand. If it decelerates, our issuance could decelerate too, back to 10%. We do not have yet a long-term view on what the level should be. We don't want to set long-term targets yet because that would require us to make a more precise analysis of the real inflation risk on state revenues for the long term. That is intellectually fascinating but difficult to implement."

That sort of intellectual hurdle is peculiar to inflation-linked bonds. No sovereign body wishes to see high levels of inflation because despite the higher levels of taxes that it could bring in, that inflation would clearly cause damage to the local economy. And yet as issuers of inflation-linked bonds, sovereigns need to attract investors to them.