More inflation-linked bonds from non-sovereign European issuers could be a feature of the debt capital markets in 2005 as the inflation derivatives market grows.
The success of Italy’s 30-year, 2.35% BTPei last September and Cades’s e1 billion 15-year inflation-linked benchmark bond in November, the French agency’s longest inflation-linked bond to date, showed how demand for linkers has grown with the need to match real liabilities.
The fact that breakevens have widened since the first European linkers were issued shows investors are also ready to receive a lower yield in return for inflation. Linkers are less volatile than conventional bonds in a rising rate environment. And long-dated investors in inflation are here to stay.
Cades will issue between e2 billion and e5 billion of inflation-linked debt this year. Non-sovereign issuers other than Cades have been constrained by not having inflation liabilities. ?We have done some small inflation-linked deals and we like linkers,? says Horst Seissinger, head of capital markets at KfW. ?But we have to rely on a window in the swap market, and that is still developing.?
The question is, is it already developed enough? Some bankers think so. Barclays Capital says turnover in inflation swaps has increased ten-fold in the past two years.
?The market is there, but the prices aren’t in the sub-sovereigns’ favour,? says Alan James, global inflation-linked strategist at Barclays Capital. ?Why lose 4bp on asset swaps rather than just pay inflation directly? While there are more payers than takers, the only reason to issue is to raise your profile. It’s actually a hindrance that the market has developed so quickly.?
Price shift
Even the biggest non-sovereign issuer, Cades, has a much higher proportion of its assets than of its outstanding bonds linked to inflation. While the inflation-linked asset swap is wider than the nominal asset swap, Cades will restrict inflation-linked issuance.
Swap pricing could be shifting in favour of inflation-linked issuance. The Cades 13-year linker is only a couple of basis points cheaper in asset swaps than the Cades 14-year nominal, so the two markets have come back together in some maturities.
And under international accounting standards, it can be harder to use hedge accounting when paying an inflation swap than when issuing an inflation bond. That might also encourage issuance.
The importance of the swap price varies from agency to agency. KfW’s mandate says it must swap all its linkers back to floating. The asset swap has never been sufficiently in its favour for it to issue inflation-linked notes in a benchmark format. The EIB, by contrast, has some inflation exposure through its lending to UK public-private partnership projects. Payments under PPP concessions are often linked to UK inflation.
?The EIB is potentially a bigger issuer, but it could also issue nominal bonds and hedge the inflation straight out in the swaps market,? says James. ?If it wants the exposure and the headlines, it could do a big benchmark, but with small inflation-linked flows in different places it would be in its interest to pay inflation, because a lot of PPP deals have cashflow amortizing structures.?
Agencies that need to swap large, liquid inflation-linked issues must compete with non-arbitrage issuers with inflation liabilities ? primarily sovereigns. With more inflation-linked debt likely from such countries as Germany, agencies could be squeezed in a crowded market. Germany says it will meet 5% of funding needs in 2005, around e10 billion, by issuing inflation-linked bonds.
?Agencies need to swap into floating as an arbitrage to their fixed-rate issuance,? says a banker who covers frequent borrowers in Europe. ?If their nominal bonds were trading at swaps minus 3bp, when they do structured deals they’ll want to do an inflation deal at significantly better levels, swapping to minus 15 or 20bp. EIB or KfW can’t compete on price.?
Italy is regularizing its inflation-linked issuance. It has decided to announce its inflation-linked deals month by month, with decisions on maturity and size coming slightly after the middle of each month to take account of Italian inflation, and executing the deal by the end of the month so the Italian index can absorb the new issue.
?We will be able to be tactical regarding the shape of our curve, which is quite steep but is expected to flatten,? says Maria Cannata, director general of public debt management at the Italian Treasury in Rome. ?We are also taking into account the fact that newcomers are expected in the market, such as Germany and other sovereigns in the 30-year sector.?
