Inflated expectations

In recent years, the wisest heads of all have been caught out, more often then not, when seeking to issue sage forward guidance on prices and inflation.

At times, no one seems to be able to know what is going on, or what will happen next. Bureaucrats at the European Central Bank watched with passivity as prices tumbled for three years, clinging vainly to the sacred belief that, sooner or later, they simply had to rise. Only when the eurozone tipped into deflation in the final month of 2014 did the ECB act, rolling out European-style quantitative easing.

Inflation has soared in some key emerging markets (Brazil, Russia) while sinking to multi-year lows in others (India). The threat of deflation – distant, to be sure – is even stalking the United States, where the 10-year breakeven rate dipped below 1.4% in late January, a six-month low, forcing leading policymakers to rethink the merits of pursuing a tougher interest rate policy.

And that is before considering the stubbornly low cost of energy and commodities. Who, after all, would have predicted two years ago that the price of a barrel of oil would be limping along at around US$30? Low input prices are a blessing for some (see resource-poor India) but they constitute a new sort of headache for central bank chiefs.

In January, ECB president Mario Draghi was forced to present the case for a renewed round of monetary easing, given this additional downward pressure on prices and wage growth. Eurozone inflation was just 0.2% in December 2015, according to the latest available ECB data.

It has been a confusing time too for bond market investors and strategists, particularly those responsible for making the case for inflation-linked bonds.

“Investors were not expecting the further sharp fall in oil and commodity prices seen over the past months,” said Khrishna Sooben, an inflation-linked strategist at Barclays. “This, alongside broader macro concerns, (such as China and the broader emerging world), has indeed had a serious impact on demand for and valuation of inflation-linked bonds. With the market pricing inflation to remain low, you might have expected issuers to ignore linkers”.

Another strategist said: “Given China’s problems, low oil prices, concerns about the strength of the US economy, and perpetually sluggish growth in Europe, I would expect inflation-linked bonds right about now to be about as popular as smallpox.”

Strange but true

Yet, strangely, that has not happened. True, linkers have not exactly been setting the debt capital markets world on fire. Activity has been sluggish in some months, and disappeared entirely in others. But deals have continued to pepper the market over the past year, with activity emanating from the usual suspects, as well as some unusual quarters.

Last July, Russia surprised many by printing its debut linker, which raised Rs75bn (US$1.3bn) in a sale that was heavily oversubscribed. The transaction, a rare success for a country under the triple pressures of low oil prices, Western sanctions and its own lack of internal dynamics, proved to be a hit for Moscow, which joined Brazil, Mexico, Turkey and South Africa as a select grouping of emerging markets sovereigns successfully to print inflation-linked debt.

The Republic of Italy also revisited the market in October, completing an inflation-linked euro benchmark that managed the rare feat of being both long-awaited yet unexpected. The lower/medium-rated sovereign (Baa2/BBB–/BBB+) priced a €3.5bn (US$3.9bn) September 2032 linker that was two-and-a-half times subscribed, with fund managers well supported by insurers.

And the new year has started well enough. In January, Germany and the UK’s Debt Management Office respectively issued linkers with 10 and 30-year maturities. South Africa, though, struggled with a February print of 2033, 2046 and 2050 linkers, selling just R430m (US$27m) of the R650m on offer.

Why has demand for index-linked bonds remained solid, for most deals at least? The answer lies in a mix of innate human optimism – the assumption that matters will improve, or at very least that any asset class is driven by economic or financial fundamentals that always return, sooner or later – and the more basic need among issuers to vary their sources of funding.

One of the curiosities here is that the asset class continues to be favoured by sovereigns facing very different pressures, from the US (reasonable growth, uncertain inflation outlook) to the UK (reasonable growth, flirting with deflation) to the eurozone (low inflation rate, slow growth). One would expect in this strange world, said Valentin Marinov, head of G10 FX strategy at Credit Agricole, that “demand for inflation protection would be stronger in the US than in the eurozone”.

Yet, broadly speaking, the demand for linkers remained strong through last year and into the first weeks of 2016.

“The commitment of big sovereign issuers such as the US, UK, and major eurozone [governments] has not fallen,” said Barclays’ Sooben. “They are still very committed to the asset class. You’ve even seen the likes of Spain and Russia enter the fray in recent years, possibly because those sovereigns view linkers as a prime opportunity to diversify their funding sources.”

Optimism reigns

Mohit Kumar, head of interest rate research and strategy at Credit Agricole, returns to the subject of confidence in humanity’s future. Demand for inflation-linked bonds among SSAs would remain strong through 2016 and beyond, he said. True, prices across the Western world, from the US through Europe and Japan, remained worryingly low and may well remain in the basement for years to come.

But even here, investors and issuers can find reasons to believe in a better tomorrow. Despite the recent stumble, inflation remains in positive territory in the United States. The European Central Bank’s commitment to quantitative easing, meanwhile, has been a godsend to harried sovereigns and institutional investors, not least because it offers solace that the world’s largest economic trading bloc is committed to fighting deflation.

“In the eurozone, QE is in full swing,” said Barclays’ Sooben. “Investors see that the ECB is committed to injecting both growth and inflation into the eurozone, and that may help drive the demand for linkers going forward. Some investors out there who are looking at this asset class are saying to themselves: maybe it makes good sense from a long-term perspective to buy inflation-linked bonds.”

And that, in turn, has all the ingredients for creating a virtuous circle. The logic here is simple and clear: the ECB takes a view that QE is the only way to combat falling prices and this mollifies sovereign debt offices, which start to believe that prices in the long term must, eventually and ineluctably, rise.

Compelling pricing

That leads to the final piece in the puzzle: valuation. It might at first glance seem a tad unusual to be buying into an asset class designed to mitigate the negative impact of rising prices on one’s assets under management.

Yet most investors, issuers and policymakers, said Credit Agricole’s Kumar, believe that “inflation will pick up again” – it is more a matter of when rather than if.

“So, if you are picking up linkers now, you are doing so at very, very low rates,” he said. “For me, the big question when I buy any security is whether it is cheap, and right now, linkers are extremely cheap.”

Some bond investors are already reflecting that thinking. Michael Krautzberger, who heads up BlackRock’s euro fixed income team, said markets were discounting any rise in prices, and tipped eurozone inflation to hit 1.5% as soon as oil prices stabilise.

That suggested inflation-linked bonds were undervalued, an outlook that led Krautzberger, who leads a team that oversees €60bn in European bond assets, to increase his exposure to such debt.

So what lies ahead? Emerging market sovereigns may struggle to benefit from the asset class, at least as long as global volatility persists and oil prices remain low. South Africa’s relatively recent struggle to complete a relatively small sale of linkers hardly bodes well, while Russia’s blowout sale last summer also reflected the lack of viable investment opportunities in the world’s 10th largest economy (of the Rs300bn in orders, some 90% stemmed from Russian pension funds).

Yet it seems reasonable to assume that sovereign governments in the Western world will continue to issue inflation-linked bonds. And that investors will continue to snap them up, comforted by the knowledge that central banks in the US, UK, eurozone and Japan all remain determined to defeat deflation, just as they once fought to control runaway price rises.

Credit Agricole’s Kumar said pension funds and insurance firms “will remain big buyers of linkers, as their liabilities are tethered to inflation expectations.

”Besides, linkers are cheap when compared to nominal bonds. They may not make much money for you over the next few weeks or months, but over the next two to five years they will – and they will make far more money for you than nominal bonds.”