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November 2001

An attractive product in the shop window





"Why do car companies sell different models?" posits a banker. "They hope that by diversifying what they sell they'll capture a bigger audience and reduce their overall cost of funding." And so it is with the new French issue linked to the eurozone price index. "This is another product range in the shop window," he adds.
At the recommendation of the Agence France Trésor (AFT), the debt agency for the French finance ministry, the French government decided to issue a bond linked to the eurozone index (OATei). This is the first offering of its kind.
AFT CEO Sylvain de Forges says the government made this decision because he was told the time was ripe. As to why it decided to issue in such a low inflation environment, managing director Christophe Angely, in charge of the issue at Barclays, says it looked at the bond issue in July/August this year. "At that time the economic context was far different," he says. "Now, it's possible there is a recession in front of us. With a diverse range of potential investors, some will not want to buy it because they will think there is inflation ahead. Others will say 'if the market rebounds we will soon have inflation'.'"
Paul Thursby, head of fixed income at Baring Asset Management, says: "I'm pleased they're doing it now. We're at very low nominal yields and low bonds. It's hard to see inflation realistically going much lower without there being a major dislocation, which means that it's likely they'll go higher at some stage." So, if we're set to experience increasing inflation, these index-linked bonds will provide more security than others.
The OATei is linked to the harmonized eurozone price index (HCPI ex-tobacco), which is published by Eurostat. This bond offers inflation protection for both the principal and coupons. In the event of deflation the principal is guaranteed. The volume for the issue was reduced from e9.4 billion to a final amount of e6.5 billion ($5.9 billion), illustrating the demand for this issue. Maturity will be July 2012 and settlement on October 31. With 288 orders in the book de Forges hopes the book will "reopen possibly early next year".
This issue is aimed at investors globally. Being linked to the eurozone (OATei), as opposed to the French price index (OATi), has attracted a more global mix. Non-French investors' liabilities are likely to be linked to an inflation index other than the French. Some 38% of outright investors were from within the eurozone, excluding France, and 35% from outside the eurozone (UK: 17% and US: 13%). Although the eurozone index may not be perfect for these investors either, it should prove to be a better fit with their liabilities.
More specifically, the issue is aimed at long-term investors such as insurance companies and pension funds. Index-linked bonds are a good fit for pension funds since part of their liabilities are linked to inflation. They also attract mutual fund investors. Thursby says: "I think these real yield bonds are very attractive as investments. We certainly use them a lot for our retail type, mutual fund clients. A key feature is that real yields are pretty high and with the economies slowly growing, it's easy to see real yields coming down." That is, real yields on non-index linked bonds will come down. This, along with increasing inflation, will make index-linked bonds more attractive.
The major difficulty facing the lead managers, Barclays Capital, Deutsche Bank and SG Investment Banking, was pricing the issue. Angely says: "It's a new product. The OATi was an imperfect benchmark, which is why the analyst decided to price it on the real yield at 2.98%." Daniel Pfaendler, debt research analyst at Dresdner Kleinwort Wasserstein, feels that close to 3% was rather cheap.
Baring's Thursby says: "I was hoping it might come a bit cheaper. It is at a premium to the French, which you'd expect because inflation in the euro area should be higher than in France. But with the US trading at 3.1 and France 3.25 I think we'll want to watch and see how it performs before we get too heavily involved."
"Currently it's been priced as though there was no inflation," says Thursby.
Break-even inflation is very low. That is, the comparison of the real yield of these bonds and the nominal yield of the equivalent government paper, which indicates how the market is pricing inflation for the future, is very low. Angely says: "Everyone has their own view on that. If you try to imagine what would be break-even inflation in the eurozone, you have to define what the eurozone is in 10 years time."
This eurozone-linked issue will not appeal to everyone. French national entities that consider they have liabilities measured in terms of French domestic inflation will continue to prefer the OATi, linked to national inflation.
Falling inflation may also deter some investors. Pfaendler says: "In such an environment inflation-linked bonds might not be the best performing assets because nominal yields are coming down, mainly because inflation is falling, not because real yields are falling."
However, index-linked bonds can offer investors more security in terms of the future real purchasing power of their money.
Thursby says: "I think it's just how they're received and are they pricing it right."






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