Linkers seek new direction

WHEN ITALY JOINED the e70 billion European inflation-linked bond market last year with a five-year issue, investors welcomed the move and banks highlighted it as a trigger for a wave of new interest in the instruments.

But the success of the deal was not driven by demand for five-year inflation in itself. Rather, because so many market participants had been using inflation-linked derivatives, they needed to hedge their exposure with five-year paper. That meant that derivatives desks were among the most active buyers of the bonds.

This relationship between inflation-linked bonds and the related derivatives is peculiar but, thanks to the relatively good development of the long end of the curve, it is unlikely to spark issuance at other maturities.

"When you are trading derivatives the question is how to hedge them," explains Philippe Challande, an inflation trader at BNP Paribas. "Do you have a bond or do you take some risk. For the five-year euro area there was a lack of bonds in the short maturity." That quickly created an imbalance. The BTPei 2008 resolved that, and despite the small lack of bonds in the 20-year to 25-year area, the outstanding 15- and 30-year issues from Agence France Trésor (AFT) make it easy to interpolate that gap in the maturity range.

The retail demand that created that five-year imbalance came largely from the widely distributed hybrid retail products, which have been particularly popular in Italy. These are designed to pay investors either an equity index tracker rate or inflation, whichever is the highest.

It is easy to see why these products are attractive to retail investors. They work almost like a principal-protected instrument, giving buyers the reassurance that, at the very least, they will have the same capacity to buy goods and services with their funds in the future as they do now.

The big question, then, is why pension funds and insurance companies are not equally keen to take inflation exposure. One reason is that some funds and central banks are simply too big. If they decided that they needed to incorporate a large inflation-based element to their investment strategy, they could immediately require e10 billion of exposure, which would be a large amount for a new market to absorb.

Nonetheless, the asset class is gradually becoming established. "If you take it to the logical extreme, everyone would prefer real bonds to nominal bonds," says Alan James, global inflation-linked strategist at Barclays Capital. "I think that is a step too far. Inflation-linked bonds will be very significant but there are not that many natural issuers in the corporate world. It has become an independent asset class that cannot be ignored in a mixed investment portfolio."

Agence France Trésor can generally rely on placing 20% of its linker issues with funds and insurance companies [see AFT reflects on a new asset class, this issue], but because of the long approval processes that these funds need to undergo before investing in new types of products, they have been slower to invest in bulk than had earlier been predicted. Luckily, the strong interest from hedge funds has taken banks and issuers by surprise.

"For hedge funds, inflation is a great tool to express a view," says Justin Excell, head of inflation trading for UK and Europe at Barclays Capital. "It is another tool to express a view about what is going on in the world. If it wasn't for the hedge funds, the market would be all on one side."

Rich Herman, European head of rates at Deutsche Bank, agrees. "Hedge funds' job is to spot trading opportunities, and they see linkers just as another asset class," he says. "And they have got so much money that they need something to invest in."

Hedge funds are therefore taking positions on a range of different points, including real inflation rates, break-even rates and inter-currency spreads. Bankers report that there is such a range of derivatives contracts available that none of them has yet become dominant.

Corporates are also keen users of inflation derivatives, often because they are unable to issue linker bonds. "For corporates often the issue is not liquidity but other subjects like taxation, accounting or system problems," says Challande at BNP Paribas. "We are closing deals now that we have been working on for one or two years." Over the next five years or so, linkers may come to make up 10% to 20% of many corporates' debt profiles.

But aside from companies involved in construction or project finance, very few issuers are really interested in paying inflation. And many are more focused on building a benchmark status with nominal bonds and in experimenting in different currencies rather than using a new way of raising debt.

There are exceptions of course, including French rail infrastructure company Réseau Ferré de France's (RFF) March 2004 tap on a 2023 linker bond, taking the total outstanding to e1.4 billion.

Many corporates seem to be using inflation derivatives rather than issuing linker bonds. "We would say that in the European market there is plenty of depth to do that," says James at Barclays Capital. "If you want to be a payer of inflation there is growing interest in receiving it. Most corporate issuance is swapped. Most are not interested in inflation at all."

So while very few issuers would be interested in launching structured products such as the ones that were so popular in Italy, some are happy to issue inflation and swap out of it. But a problem with liquidity in some derivatives remains.

"It is relatively difficult to unwind inflation-linked swaps," says James. "If you are buying them with a view to unwinding them in a couple of months' time, you may find that liquidity is very poor. Generally you have to wait for a year before you can unwind."

This creates a strange anomaly. On the one hand, corporates are using inflation derivatives rather than issuing linker bonds; on the other, the derivatives market is too illiquid for them to issue linkers effectively. No doubt as the bond and derivative markets mature further, market restrictions on the use of these instruments will diminish.