Inflation-linked bonds: Making sense in emerging markets

The biggest challenge facing the emerging markets is not the credit crunch; it’s inflation. Surging price rises are evident in all developing regions with buoyant economic activity, high food and energy costs and currency pegs all playing their part, depending on the specific country.

In South Africa the inflation rate is more than 10%; in Russia it’s 15%; in Argentina it is probably 20% despite what the official figures state. Inflation is becoming a headache for policymakers in Asia and the Middle East too.

Emerging markets investors are grappling with the issue too. Last month, Sinopia, an asset management subsidiary of HSBC, announced that it was raising money for what it believes are the first emerging markets funds to invest exclusively in inflation-linked bonds.

Given how some developing nations have suffered from prolonged bouts of inflation, and even hyperinflation, it’s perhaps a surprise that no dedicated fund has been established before. There are two main reasons: limited diversification of supply and insufficient liquidity.

Barclays Capital’s local-currency Emerging Markets Government Inflation-Linked index (EMGIL) has a total market capitalization of $215 billion. The size compares well with the more developed markets – the UK Government Inflation-Linked Bond index, for example, has a market cap of just over $300 billion. The issue with the emerging markets is that Latin America accounts for the vast majority of the overall index capitalization, with Brazil by far the largest market, with a weighting of 64%.

Governments from other emerging regions are beginning to issue linkers but they are few and far between. Poland, Turkey and South Korea have only one bond outstanding. The latter is one of only two Asian countries to have issued an inflation-linked bond. The other is Japan, which obviously is not captured within the EMGIL.

Another drawback to emerging market linkers is liquidity, which can be tight except for those bonds issued by the biggest borrowers. Chilean and Colombian inflation-linked bonds, for example, can be difficult to trade on a daily basis because their issue sizes tend to be relatively small. Some countries’ linkers, such as South Africa’s and Korea’s, are only really traded when there is a new auction.

Clearly supply needs to increase. Whether governments in the developing world like it or not, inflation is a reality. In that context, linkers make sense. Greater supply of inflation-linked bonds would not only benefit investors by providing them with a hedge against unexpected price rises; they would also give them an alternative to investing in commodity funds every time inflation crops up, which ironically worsens the problem.

Linkers can be beneficial for issuers, too, not least because they give treasuries greater credibility in their fight against inflation. If a government issues linkers, it’s not in its interest to let inflation get out of control. Argentina is testament to that. Its inflation-linked bonds are producing negative returns this year.