Inflation-linked products debate: Putting a price on inflation

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The market is relatively young but it has had a brutal education over the past year as the financial crisis has swept through every corner of the financial markets. Where next for inflation-linked products?

Delegate biographies: Learn more about the panelists 


Executive summary

• The inflation-linked market has faced its own set of difficulties in the financial crisis

• Inflation is no longer the key issue. Now investors seek deflation protection

• Volatile commodity prices have had a big impact

• Government debt managers are now more alive to counterparty concerns

• Pension funds face a difficult choice between volatile equities and low-yield inflation-linked bonds

MH, Redington 2008 was a cataclysmic year. What has the credit crunch meant for us?



CA, RBS The inflation market is still young, so supply and demand is crucial to how it operates and prices. Several years of favourable terms for long-dated corporate issuance, cheap monoline wrapping and attractive asset swap levels meant that we came out of 2006/07 with our most balanced market yet, particularly in the UK. For the first time, even inflation swaps were trading at a discount to bond breakevens. It was oversupply. Corporate issuance terms were favourable and they were probably frontloading. The slowdown in bank lending put a stop to the transactions that brought in the much-needed supply of derivatives, and then property transactions dried up. We started the year on the back foot. That, combined with a degree of liability-driven investment (LDI) hedging in the first quarter gave the swap market a huge squeeze. There was a sudden steepening of curves, particularly for the UK, even before hedge funds and leverage funds started de-leveraging. The market was stretched, institutions were in trouble, transactions were unwound and liquidity dried up.DD, Axa Two years ago we thought inflation had been conquered. In contrast 12 months ago the issue was the rise in oil and food prices, the growth in the Chinese and Indian economies causing demand on resources, and demand for inflation-linked bonds to protect against inflation. Now we’re almost back to where we started. Because of the global downturn we face deflation or disinflation. The difference is that we now believe it’s a cyclical downturn in inflation rather than that inflation has been conquered for all time. Inflation-linked products are less in demand and investors are also focusing on deflation protection.MC, BGITowards the end of 2007 we felt on the precipice of a big slowdown. Growth was slowing from the level of the previous few years and the housing market had tipped over. Much of the market had got short inflation because of these factors but were squeezed back in with a large deal unwind at the start of 2008. It was then that the commodity rally really accelerated and the risk grew that inflation would be a problem. Not demand-pull inflation, cost-push. That means something completely different for central bankers and inflation investors. In that environment being long break-even inflation was the trade to have. In July, the picture changed as commodity prices peaked and breakevens were aggressively sold off.MH, RedingtonFrom a debt management perspective, where do we go from here?



JP, DMO 2008 heralded new challenges for government debt managers. We started the year with the backdrop of weakening growth, rising deficits and therefore rising funding requirements. Mid-way through the year governments were funding bank recapitalization plans in addition to deteriorating fiscal positions. Issuance suddenly doubled in what was already a record year. Funding in the gilt market has been successful to date but we have become increasingly alive to the risks our counterparties face. The structural demand for products, both inflation and conventional, is still strong, particularly for the longer-dated issues. But it introduces new risks around how we distribute that stock to investors, with banks’ capital constrained and risk appetite low.SM, FortisA lot of the inflation was due to pass through commodity prices and we are now living through the other side of the equation. Prices are collapsing, so there is a reduced element of carry in inflation-linked bonds. The short ones are going to suffer, at least in the first quarter. The reason to sell inflation-linked bonds to clients is not so much on the carry and inflation as on the real yield, which is attractive at these levels for long-term investors. MH, Redington  Commodities have been a key theme with unprecedented price movements. We have the spectre of stagflation, possibly deflation, yet commodity markets are positive. How does that filter through into inflation markets?

CA, RBS Inflation markets say little about where we think inflation is going and all about supply and demand for the product. Over the last few months, particularly in the US and Europe, at the front end of the curve you have the fallout of commodity prices and the carry impact. If we jump forward 12 months, where will the year-on-year prints come out as a consequence of the commodity highs and what impact will that have on the three-month, linked bonds with their carry adjustment? At the same time people are jumping out of Tips (Treasury inflation-protected securities). The banks’ policy might be to hold treasuries, but Tips have suffered because of perceived illiquidity. As implied breakevens push lower and tend towards zero and through zero, people are becoming longer inflation and needing to sell it. That was the reason, in September, that one-year inflation in the US dropped 500 basis points in two weeks. There are people who are short of, not just 0% floors, but –1% to –2% floors. Whoever considered –2% deflation? Suddenly I have a massive intrinsic in my option price because the one year is trading at minus four! What commodity prices are doing is relevant. But curves have steepened at the front more because of embedded option situations than commodity prices.MH, Redington  Are inflation markets accurate predictors?



MC, BGI The breakeven rate is a forward-looking indicator and shows a higher correlation with inflation a year or two ahead. It is dependent upon the point on the curve you are looking at, but generally the markets provide better forecasts than economists.


SM, Fortis The markets are better than economists at predicting inflation, but you can develop simple tools that allow you to beat the market and add value. There are three elements: the seasonality pattern is the dominant inflation forecast. Second is the price of commodities. If you tell me the price of oil and other commodities in the future then I can tell you what inflation will be. The difficulty lies in predicting commodity prices, rather than inflation. Third is the unemployment rate. People have underestimated its impact because unemployment rates have been low throughout the last cycle. The economic downturn will push unemployment back higher. Economists or investment managers may forget to take this into account when forecasting inflation.MC, BGI The Philips Curve has been a useless estimate of inflation recently, but we are moving back to an environment where it might have value again.


MH, Redington  Key liquidity in an appropriate form is critical to developing and supporting the inflation market globally. What are the supply aspects?


JP, DMO Index-linked gilts have been a very important part of our funding programme, averaging around 25% of overall issuance. We have been a regular supplier of inflation and, as our funding needs have risen, the amount of inflation we have been paying to the market through index-linked gilts has increased. We try to balance needs across the conventional and index-linked curves. A good feature of the UK market is the length of the average duration. On the other hand that gives us a long curve to maintain. The shape of our issuance programmes and our portfolio set-up need to include a measure of inflation and nominal risk, and we want diversification across the investor base because we think that gives us a more stable cost of funding over time. The inflation market also gives us a degree of fiscal insurance because a lot of the government’s revenue streams are inflation-linked and/or linked to nominal GDP. We try to develop a strategy that meets the aims of investors and our own long-term supply preferences as well as balancing the distribution mechanism of how we can sell to the market. We know there is structural demand, therefore conventional and inflation-linked gilts, but demand will not necessarily coincide with the timing of auctions. We have to make sure that we get best value for the Exchequer by maintaining investor interest across a range of nominal and inflationary bonds.

Liquidity issues

MH, Redington  Should issuers be doing more? If so, why aren’t they?



DD, Axa Government issuance from the UK DMO has been very successful in expanding the yield curve, going out towards 50 years, and balancing the need for large, liquid issues with the need for spreading issues across maturities. The problem with the lack of liquidity within the UK index-linked government market is that a lot of stock ends up effectively being bought and held. Hence we won’t get the same liquidity as in the conventional market. Meanwhile, UK non-government issuance is concentrated among supranationals, utilities and PFI issuers. We would prefer a wider range of issuers and different maturities, but that will probably not happen.MH, Redington  What non-conventional sources of inflation are available and how can these best be tapped? The BBC White City securitization provided an attractive source of limited price indexation. Banks have been creative in tapping clients for these types of inflation. Why can’t that come about again to help reduce some of the bond versus spot risk you run?CA, RBS These transactions are occurring again. Fewer commercial property transactions are going through and a lack of appetite for bank lending into those sorts of deals is holding things up. Corporates have inflation exposure that would make them natural issuers but their investor base has concentration limits in how much paper it will buy. Changes in accounting treatment could enable corporates to issue nominal bonds and do swap overlays themselves to synthetically create their own inflation-linked issuance. That is potentially one route for additional supply. Property transactions are occurring. In Europe, there is an oversupply of infrastructure projects being swapped. The amount of CPI swap floats has weighed on the inflation swap curves and, from a point of view of historically high breakevens, resulted in low unappealing real rates. It has been increasingly difficult to place that. With rising commodity prices, there is a tendency to exaggerate the spread of domestic curves against euro, and as we come in they’re narrowing. Spanish swap breakevens, for instance, have contracted dramatically. A degree of convergence will come, but that market particularly has suffered from oversupply. SM, Fortis Considering the dislocation in the bond market, it is difficult enough for many corporate issuers to bring even nominal issues. Where Italy and Germany have developed inflation-linked programmes, there may be an opportunistic aspect. The French programme is better for investors because it has high visibility, so you know the pattern of issuance. Germany and Italy would be well advised to move in the same direction. It may not be as profitable on single transactions but in the long run they would benefit if their issuance pattern were more readable and less opportunistic.MC, BGI I am not sure. A debt issuer with a mature product may follow a predictable, regular programme of issuance. A relatively new issuer, such as Germany, still growing its investor base, might find the flexibility and scope a real benefit – to bring in supply when breakevens are high, withdrawing it when there isn’t appetite. That lack of flexibility hampered Japan to the point where its finance ministry is now a net buyer, not seller, of JGB paper.SM, Fortis Japan’s problem is a lack of domestic support. In Germany, there is a genuine demand from pension funds and insurance companies.
DD, Axa Having flexibility is important even for an established issuer, like the DMO in the UK. Given the market volatility over the last 12 months, it outweighs the predictability advantages of a rigid schedule of issuance.
MH, Redington  What about liquidity in the secondary market? The diminished appetite from bank trading desks and fast money accounts has impacted considerably.
MC, BGI It makes the transfer of risk more difficult. But the market is operating more effectively than in Q4 of 2008. Liquidity is not what it was in 2007 and we expect to pay higher bid-offer spreads. But while volatility is proportionally higher, our scope to generate alpha has not diminished. We don’t need to trade in as big a size, in dollar terms, to generate the same risk. The dislocations mean opportunities. If you can scale your trade to the right size, the landscape for alpha mining is quite rich.MH, Redington  If we include the embryonic Asian markets and the Indian and the Chinese economies, the future demand for infrastructure should engender enormous supply. Does the demand exist to satisfy that?
JP, DMO UK pension funds typically would hedge their inflation risks most closely with UK inflation-indexed supply. Shorter-term holders may look for relative-value trading opportunities in foreign inflation-linked issues. In the UK, there has been interest in inflation-linked gilts from overseas, particularly in Europe and the US.SM, Fortis Asia has a few important sovereign wealth funds and there should be an appetite for Asian and even Middle Eastern inflation.



MC, BGI We have seen interest from Asian investors in global inflation-linked products, but does that extend to their domestic inflation-linked indices? There is issuance out of Japan and Korea, for example. Asia ex-Japan may well be the next area to develop, because there is appetite for a global inflationary product from the region.CA, RBS The weighting in an Asian basket is much more in favour of food prices, so they have suffered a more acute move in headline inflation. Asia experienced an acute rise in inflation during early 2008, and we read about all these products that weren’t available to them. We spoke with potential government issuers in Hong Kong and Singapore that are just not issuing. They could see the need for the product and were happy to be involved in its promotion, but didn’t want any money, so had nothing to offer. India has issued in the past, so there is precedent. As Matt said, Korea also issues, although that is not a market. From time to time it taps a few W100 million and it has bought and held.

Development potential

MH, Redington  In Australia, from a government perspective, there has been very little CPI issuance and the bedrock of the supply comes from public-private partnerships. Is there scope for that market to develop?

CA, RBS Australia has a legacy government issuance market of bonds that aren’t tapped regularly, if at all, and large structured trades from time to time. Those flows drive the market and there have been a few trades in Australia this year. Breakevens have come from 4% at the start of the year down to below 2%. The explicit demand in linking for pensions is not there in the same way as in the UK. Funds trade it as part of a global product.MH, Redington  Insurance and long-term savings have always been the bedrock of demand for inflation-linked products. The market now has negative real rates in many instances, so will the demand side be skewed towards pension funds and long-term savings providers?DD, Axa Yes, because they are the main investors with liabilities linked to inflation. Defined benefit pension schemes are in decline, so there will be a fall in demand over 15 or 20 years. It will be interesting to see how pension funds cope over the short term. If RPI turns negative as expected, will UK pension funds decrease payments to pensioners?SM, Fortis Europe is behind the UK but will catch up. The pension system is still mostly pay-as-you-go, and as they have an excess of funding, inflation-linked bonds would make sense. But I would not ignore sovereign wealth funds. They are similar to pension funds in investment policy, so need protection against inflation too. MH, Redington  Is there much demand from pension funds for inflation alpha?



MC, BGI There will always be the temptation to try to generate alpha, but primarily the interest is in the beta. As David said, it will be interesting to see if pension payments fall as a result of negative RPI. RPI could hit its point of greatest deflation around September this year, which is the point at which millions of state scheme rates are set. While we know that a large proportion of pension schemes’ payment changes are theoretically floored at zero, we have never needed to test this. In such a politically charged period as a recession, will annual changes genuinely be floored at zero? Will state pensions be cut at the 2010 budget? If not, what does that mean for pension funds with a large allocation to inflation assets?DD, Axa You can’t imagine [UK chancellor of the exchequer] Alistair Darling announcing: "Your pension is going down because RPI has been negative over the year." Do you have much call from international investors for the deflation floor on index-linked gilts, Joanne?JP, DMO We held a public consultation on index-linked design, including the demand for a deflation floor, six or seven years ago; at the time the market said it wasn’t prepared to pay for that option. Given that we would potentially be losing some of the fiscal smoothing properties of inflation-linked gilts by introducing a 0% floor, if the market wasn’t prepared to value that option, we didn’t feel inclined to introduce one. We reiterated this position at the time of the ultra-long consultation in 2004/05. Most of our index-linked gilt issuance is at long maturities, and there would seem to be little expectation of inflation being negative over the long term. So it comes down to a trade-off between the potential loss of liquidity from introducing a new, non-fungible inflation-linked gilt against the perceived advantages to an investor of short-term notional cashflow protection. We would need evidence of new demand for a deflation floor from a strong core of investors to reopen that debate.CA, RBS If there are no floors anywhere, you shouldn’t be overly concerned that deflation leads to erosion of your principal. By the same token, if the liabilities are permitted to fall, we’re only speculating the worth or otherwise of the floor of the inflation-linked bond because we’re concerned that, outside the scope of whatever is documented, there might be political pressure to write for free a 0% floor. If it’s consistent, there isn’t a problem. If there is an inconsistency, because people consider introducing a floor and you then have a mismatch between your asset and liability, that becomes a problem. We have never tested any LPI collaring in this period. This year has been an exercise in testing pricing models, settling contracts and transactions where the sign of the payment would reverse if the rate goes negative. The day-to-day mechanics of what I do are tested, but the softer elements of how we enforce contracts and what gets passed through, especially with the political weight of the current climate, is an unknown.MH, Redington  Should pension funds be mindful of real rates while trying to opportunistically and tactically acquire inflation assets, and then worry about the nominal when rates are at more interesting levels?DD, Axa When pension funds see the low real rates at the long end of the UK market they are forced to look into other assets. But the volatility in the equity markets may also frighten them off. There’s an unenviable choice they must make between volatile equity markets and inflation-linked bonds that offer low real yield levels.

Timing focus

SM, Fortis The low real yield in the UK is less of an issue from a global perspective. Even in October, we could buy long-term Tips at a 3% rate, which is attractive long-term. We advise long-term investor clients to look at real rates and focus on getting the timing right to build a core position in inflation-linked bonds. There will be more or less liquidity depending on which country you go to, but a long-term investor should weather that and take advantage of opportunities in the first half of 2009 to lock in high real yield.CA, RBS With the absence of the hedge funds that traditionally supplied a back stop for skewed markets, LDI participants are surprisingly willing to challenge extreme views and actively manage, and look to be overweight or underweight appropriately. To a market maker, it is not obvious what an LDI client is looking to do. It has worked well for us because we have generated more opportunities for both sides. Business continues to develop because the scope for reacting to opportunities seems greater. With the lack of leveraged fund activity, the swings are more violent. That may scare people off, but it also provides interest and opportunity.MH, Redington  Is it acceptable to take relative value risks?



DD, Axa It all depends on the investor’s attitude to risk. It is easy to dismiss LDI as just one form of investment, but LDI has always covered a range of approaches. Some investors specifically want to tightly match their risk. Others may wish to broadly match the maturity profile or inflation exposure of their risk, and will give the investment manager scope to move within certain parameters. During the last 12 months of volatility, pension funds have been reminded, as other investors, of all the risks involved in managing their funds. For example, they are looking afresh at counterparty risks on swaps, stock lending and repo markets. Some may never have looked at this in quite so much detail before, and that may push them to match liabilities more exactly, allowing their investment manager less freedom. LDI has always covered a range of approaches, and that will continue.MC, BGI You’re right. The LDI approach is simply providing a more bespoke beta solution to the client’s investment objectives. Demands aren’t necessarily fulfilled by market-capitalization-weighted benchmarks, which were almost always used until five years ago. I expect LDI to become more common as beta needs are addressed more. Pension funds currently seem to have more appetite for the physical solution. Counterparty risk is more of an issue this year than last and right now asset swap spreads favour the investment in index-linked gilts. It is a more relative-value, short-term theme, but we expect more demand to be satisfied with physical supply. Good news for Joanne.JP, DMO Yes. Pension funds and their advisers tell us there is still strong demand for long-dated, inflation-indexed gilts. The swap market has satisfied some of that demand in the past but, as Matt said, the flexibility that the swap market provides looks less valuable when swap rates are so low versus the yield on the bonds. The key question for us is whether or not pension funds will seek to satisfy that structural demand when inflation expectations are generally so low.MH, Redington  How relevant were hedge funds to the inflation market?



CA, RBS They were probably more relevant in the development of more structured products. When structured notes started trading and embedded floors were identified, there was interest from the hedge funds. There was a relative value trade for CPI floors against interest rate floors. We have tried to promote structured inflation products and get the options market more active. The hedge funds were very interested in range trading, inflation vol versus nominal vol and how different structured products would either provide big demand for or supply of inflation vol. They were very interested in inflation-linked asset swaps. Beyond that, we spoke occasionally about possible opportunities when some of the non-core indices became very stretched. But they weren’t always in a position to put plays on because for the hedge fund it has to look like you are catching the opportunity early. The reasons why those inflation markets are stretched suggest no good reason for the supply-demand dynamic to correct itself in a hurry. I don’t want to belittle their involvement, but it became clear that they all had the same trade on and were all unwinding at the same time, to cataclysmic effect.

Odd moves

MC, BGI The involvement of hedge funds was significant just after the February US CPI print in March, when we got the zero print and breakevens collapsed. The next few weeks saw very odd moves in breakevens, contrary to what you may have consider rational. It was around the time of the Bear Stearns event as well, so de-leveraging was under way. It seemed most sensible trades were underperforming and the less intuitive positions were doing well. And not just in inflation; for example, implied volatility sold off significantly – not what you may have expected considering the macro backdrop. It brought home how relevant de-leveraging was. DD, Axa You noticed how much of an influence hedge funds had been in the inflation market when they left. In particular, we saw the effects of their deleveraging trades.MH, Redington  Why aren’t more banks doing more to arbitrage inverted asset swap spreads away? Have you been constrained in terms of risk limits from being able to take advantage of opportunities?CA, RBS One is mindful of where risk is taken. Where opportunities existed, you may have been partnering up with hedge funds and looking to off-lay a degree of risk, rather than pass it all through. There are no anomalies that wouldn’t have been there because hedge funds had always come in and arbitraged them all away. Inflation markets, more than any, are subject to the supply-demand irregularities and structural anomalies that create these situations. Asset swap levels are built, in theory, at middles out of an inflation-linked bond price, an index swap price and a nominal swap price. That can look appealing, but with all of these bid-offers wider now it is not as straightforward. There is a notion that, where it wasn’t possible to find a client trade, banks would off-lay risk with each other in the inter-bank market. They would both deal at mid. That is no longer the case. Bid-offers are wider because in the inter-bank market people spend money to transfer risk around as well. Will inter-bank markets dry up? Probably the reverse is true. Trade sizes may be down, but there is more activity and people aren’t just waiting for opportunities to match. Dealers are crossing spreads to off-lay risk. MH, Redington  It is widely believed that hedge funds helped facilitate immense liquidity and provided a significant amount to the supply of inflation.CA, RBS They weren’t always deemed to be providers of supply. They were looking for opportunities. These are long-dated underlyings, but they aren’t taking a long-dated view. It is a short-term opportunity to exploit something that they will reverse at the first opportunity. It is not sustainable as a provision of supply and demand. That is not to say that many transactions weren’t welcomed at the time.DD, Axa That is true. Pension funds want to protect against longer-term inflation whereas hedge funds and other leveraged investors last year said: "The oil price is going up, inflation is going through the roof, therefore we want to take an exposure to inflation over the short term". The market strikes a balance between the two types of investor. Pension funds have tended to concentrate on real-yield investment, whereas leveraged investors look more at breakeven inflation rates.MH, Redington  Structured inflation product isn’t a stand-alone market in its own right. It is fundamentally dependent on supply factors. Is that fair?

Simple product

CA, RBS I think so. The inflation market has had liquidity issues, and therefore if the underlying is suffering, any options market on that will have problems. Initially you had structured inflation notes with an embedded floor. It was a simple product, but it injected life into the shorter end of the euro inflation-linked market and created a tendency for dealers to be short of inflation vol, albeit in 0% floors and not much else. The next relevant products were inflation rangers, which came from the dealers’ desire to buy back inflation vol and an opportunity to exploit the fact that the ECB had moderate success in keeping inflation on track. Investors were more than happy to bet that eurozone inflation would stay within a narrow range, sell optionality, sell the bet that it would move outside the range and get a yield pick-up. That was very popular during early 2007. It introduced volatility, because dealers were effectively buying from investors. It was the first move in Europe away from 0% strikes. We have since broken through that range. We soared through the upside and now we have come tumbling through the lower range. At the same time, inflation markets were almost at peak liquidity. So it worked. As a market you could trade the underlying. As an options trader, if you couldn’t get out of the option by buying or selling a corresponding option, you could delta hedge it and delta trade the underlying. The cost of execution of every swap means that the implied volatility you can trade is next to nothing. If I have an option linked to 10-year inflation and I have delta exposure to that underlying, and if I am positive when it goes up I can sell some and when it goes down I can buy some, the typical bid-offer means that it has to go five basis points in my favour for me to lock in one, let’s say. Implicitly the volatility of the underlying is a fifth of what we are observing, so mechanically it is difficult to implement. If inflation is suffering from liquidity as a global asset class, then structured inflation is suffering more. It is not the time to be looking at that. MH, Redington  There could be potential demand for a structured inflation product from a retail base.



SM, Fortis I am not convinced there is much value in this type of product, even at the retail level.



CA, RBS The structured product that people are interested in is 0% floors. People are concerned with deflation. It is not particularly structured, but there is demand from end users, and there is supply.

SM, Fortis The end user would be mainly in the UK. This product does not exist on the Continent. There you can protect yourself with inflation-linked bonds.

CA, RBS You can, but it is a different sort of floor. The inflation-linked bond floor protects you over the duration of that period. We are talking about people concerned with year-on-year inflation over one year. The European index-linked bonds are outstanding. They are effectively so seasoned and have so much implied indexation within them that the floor that they are carrying is minus many percent. We would have to tumble a long way from here, effectively back to the base level when they were issued. It has become relevant in the US for some shorter-dated Tips, where there’s real perceived value in the fact that we could find the index printing lower than where they were issued. For transactions in existence for some time, it is not an issue.SM, Fortis But would they be the type of instrument you want to buy? If the economy recovers, inflation-linked bonds make sense. If the situation gets worse, you want real assets. We are producing too much paper, and an inflation-linked bond is just another form of paper. We want to get back to real assets.MH, Redington  What circumstances favour a derivative product over a cash product, or vice-versa?



DD, Axa The problems in structured markets and the global economic crisis are taking us back to basics — to the argument that you don’t buy something you don’t understand. If an investor does not fully understand inflation-linked swaps or inflation-linked derivatives then, for them, derivatives are not the answer. They will be unwilling to take the risk, particularly while market volatility continues.MC, BGI An obvious advantage of derivatives is that you can design a product to cater more precisely to a client’s needs. The negatives for derivatives include counterparty risk and liquidity, which you expect to be better with a physical government bond. It is often just a case of relative value and what the client needs.MH, Redington  If end users anticipate inflation via the derivative market, is that of concern?



JP, DMO The providers of the inflation swap have to hedge their inflation exposure somewhere, so there will be a link between the bond and the swap. Over the long term, if the banks supply inflation through the swap market, they need to hedge their risk, and therefore a deep and liquid swap market should help develop liquidity in the bond market as well.

Cash vs derivatives

SM, Fortis It is exactly the same in euroland. There is more demand for cash trade than derivatives because of the valuation and counterparty-risk arguments. There is no real demand for derivatives. It has to do with the cost of financing and warehousing all of those inflation-linked bonds that were backing the derivatives. The banks can’t afford it any more and the hedge funds can’t do it either. Over time, this valuation gap is bound to narrow, but I don’t know when.MH, Redington  In the light of these inversions that exist in physical versus derivative markets, the actuaries will be asking the question, what constitutes risk-free?SM, Fortis It doesn’t exist!



DD, Axa There is no such thing and there are now a lot more elements that need to be considered when matching liabilities. LDI may once have been claimed to be the panacea for exactly matching your investments. You could sleep safely in the knowledge that you had the ultimate risk-free investments. But volatility has shown, in some cases, that we may not be quite as close to that solution as we thought.MH, Redington  Is there a risk premium for inflation products?



MC, BGI Our work suggests that about 80% of the volatility in the breakeven rate is inflation expectation and roughly 15% is the inflation risk premium. About 5% is down to other factors, which we classify as relative liquidity. In theory it is related to people’s appetite to protect themselves against inflation volatility. But stripping these out from a breakeven rate to estimate the premium is extremely tricky. Identifying the direction of the value assigned to the inflation risk premium is about as close as we can hope to get. Anyway, having a good grasp on inflation expectations is far more important. JP, DMO We looked at the costs of the index-linked gilts we issued compared with the pay-offs from a notional nominal strategy. In the early 1980s, inflation typically came in a lot lower than expectations, and we were able to capture that effect in lower issuance costs of index-linked gilts. For later issues, particularly those since 2000, there has been much less evidence of cost savings because inflation expectations have tended to move lower with actual inflation. That said, what happened in the past gives little insight into what will happen in the future and we continue to feel that index-linked gilts play a strong part in our debt management strategy.MH, Redington  Does that reflect the relative youth of the market? It is easy to ascribe an equity risk premium, or indeed a liquidity risk premium.
MC, BGI To capture something second order, like inflation-risk premium, you need a huge amount of data and time.



DD, Axa The inflation-linked markets have been around for nearly 30 years, mostly in a period where inflation has been declining. But we have recently had a couple of years of increased volatility, where we went from thinking inflation was going through the roof to talking about deflation. Perhaps it is a question of getting through this economic cycle. The inflation-linked markets will be tested more in the next five years than in the previous 10 to 15.MH, Redington  We are experiencing peculiar markets where linker versus breakeven levels are unprecedented. Swap spreads have become less inverted, but is this phenomenon likely to prevail for much longer?CA, RBS There is still a comparative wariness, around index-linked bonds in terms of liquidity on a Tips side, that artificially depresses the price. There are issues of arbitrage and timing of entry. Levels look compelling, but we have seen how quickly they move, and the concern that it can go further causes people to hold back. Opportunities are there but risk appetite is low.MC, BGI There are opportunities in all sorts of asset classes. It is not just constrained to inflation. If the past year has taught us anything, it’s that a cheap asset can get a lot cheaper.