Party crasher

Inflation-linked bonds are popular, to be sure – 10 sovereigns printed US$23.3bn-equivalent in the asset class in 2017, according to data from Thomson Reuters, led by the UK (which accounted for US$8.45bn of sales), Italy (US$3.17bn) and Japan (US$2.76bn).

Issuance by the top 10 sovereigns was US$22.6bn in 2016 and US$26.4bn in 2015, driven by the same, wealthy group of developed nations. As an asset class, it is as steady and solid – and, yes, boring – as they come.

But is this about to change? We are entering a new age of uncertainty, one in which many of our current assumptions and convictions could mean much less – or nothing at all. The era of quantitative easing has either come to an end or, in the case of the eurozone, with the European Central Bank due to stop buying €30bn of bonds each month from September, will soon do so.

Interest rates are on an upward trend, with the Federal Reserve raising rates in March for just the sixth time since the financial crisis, and likely to raise them twice more in 2018. The Bank of England looks set to increase the base rate to 0.75% in May. Even the ECB, benefiting from stronger growth across the single market, is likely to pursue a tighter interest rate policy from 2019.

Investors, meanwhile, are eyeing a slew of factors, any of which could destabilise the global economy. Will Britain’s vote to leave the European Union leave the UK stronger and the EU more cohesive, or both enfeebled? Will Donald Trump’s desire to punish those states that run a high trade surplus with the US, by slapping punitive tariffs on key sectors, lead to a new era of protectionism? And have we, as many believe, reached the end of a 20-year bull market in bonds?

If you believe the answer to any or all of those answers is an unequivocal ‘yes’, then investing a bit more of your fund’s, insurer’s or endowment’s capital in inflation-linked bonds makes a lot of sense.

Let’s unpick this piece by piece. In recent months, the financial press has fallen mildly in love with inflation. It isn’t a big story – yet – but it exists and for good reason. In America, consumer prices increased 2.2% year-on-year in February, according to the Labor Department, boosted by rising wages. In the UK, prices rose at an annualised rate of 2.7% in February: slightly below expectations, but above the BoE’s Monetary Policy Committee’s inflation target of 2%.

Elsewhere, the picture is more muted, though most bankers and monetary authorities in the developed world say prices are more likely to rise than to fall going forward. One senior SSA DCM banker said that despite data from Eurostat showing annualised headline inflation easing slightly to 1.2% in February, “there is a rising expectation of higher inflation in the eurozone in the near term”.

In a March 26 Global Macro Strategy update, UBS tipped inflation in Japan to hit the Bank of Japan’s 2% target in 2019. It added: “We expect over the medium term [to see] a sustained increase in inflation” across the board.

That is leading to rising demand for inflation-linked bonds, which have, said Jorge Garayo, global head of inflation strategy at Societe Generale, “become an interesting asset class, as they are correlated [against] conventional fixed income markets but at the same time they are a defensive asset class”.

Increasing appetite

Take the eurozone. Citigroup reckons a greater volume of index-linked prints was issued in the first two months of 2018 than in any year since 2005. Spurred on by firmer prices and stronger growth, euro-area states sold €11.7bn of index-linked debt in January and February. The supply of linkers rose in France, Spain and Italy over the period, while staying flat in Germany.

The US is another country where the sale of Treasury Inflation Protected Securities, as the US$1.3trn asset class is known in the world’s largest economy, is set to grow, thanks to a stronger economy and rising oil prices. Bankers said higher net inflows into exchange-traded funds, which are a way passively to invest in index-linked bonds, point to rising appetite for linkers.

“We are seeing rising demand for TIPS alongside a perception of increased risk of future inflation – it’s particularly strong at the moment,” said SG’s Garayo. “It is reasonable for the TIPS market to grow further when, as is expected, we start to see impact from President Trump’s tax cuts and infrastructure spending plans.”

He added: “We are likely to see the US Treasury increase the size of the programme, and they will do that by issuing a new five-year benchmark each year, making it two five-years, two 10-years and a 30-year, each year. There is a chance we get an announcement as early as the Treasury May refunding announcement, for a second five-year benchmark to be issued in October 2018.”

While the rest of the developed world is ramping up issuance, the UK seems to be easing down. Britain, which has more than £400bn of outstanding linkers, is a powerhouse in the field, with UK government-issued index-linked bonds accounting in 2017 for 35% of all Gilts sold worldwide.

So the Treasury’s decision to scale back its supply of linkers raised eyebrows when it was announced in March. Was this a sign that the UK’s Debt Management Office was falling out love with the asset class? DMO chief executive Robert Stheeman pointedly noted that no other country “regularly issues a quarter of its debt in inflation-linked bonds”, adding that this “gives us pause for thought”.

Okay in the UK

Yet the truth in the UK is that inflation-linked bonds are here to stay. They are incredibly useful, particularly for pension funds and insurance firms, whose liabilities are often tied to inflation. Britain is the world’s second largest issuer of the asset class “mainly for the reason that there is a regulatory demand for inflation linked bonds, because pension funds are obliged to buy them in order to hedge their inflation-linked liabilities”, said SG’s Garayo.

And if there is a reason for this squeezing of supply, it is due to the low amount of redemptions the DMO needs to refinance this year. But that, said John Wraith, head of UK rates strategy at UBS, “will pick up again in 2019 as redemptions pick up. Demand for linkers in the UK is not declining, with pension funds likely to remain the key drivers as they continue to switch their assets from equities to long-dated and index-linked debt”.

So what else is likely to affect the demand for and supply of index-linked bonds going forward? Take a trio of factors, each integral in its own way to keeping inflation below 10% in the UK and the US since 1981, and below 4% in the euro area since 1992. The first two, technology and globalisation, have been mightily effective at containing prices by slashing the cost of production and distribution.

But could these factors be reversed? It would have been a ludicrous suggestion a few years ago. But that was before the election of Donald Trump, with his ‘America First’ mantra and clear desire to penalise importers and push more firms to manufacture in the US. Fears of a full-blown trade war, pitting China and Europe against the US, are all too real. “Globalisation is a very hot topic,” said the senior DCM banker. “If it reverses course, and if protectionism really takes off, it could add to inflationary pressures.”

And what of technology? It has been hugely effective at keeping price inflation low – but that could change if there is a backlash against the digital behemoths that dominate our world. With Facebook in the dock and European authorities threatening to break up Google, that is an all-too-real proposition.

The third factor – the West’s large ageing population – will remain a stabilising force: no one over a certain age wants to see inflation eat away at their pension.

No one who lived through the chaos of the 1970s will forget those years. That world – one in which manufacturing was done locally and strict controls made it tricky to move capital across borders – was very different from ours, an era of low growth and soaring inflation that at the time seemed to have no remedy.

But that does not mean inflation cannot return. It probably will – and when it does, will we be ready?

“We tend to mention several long-term challenges in the same breath – climate challenges, potential trade wars – but we don’t talk about inflation,” said the DCM banker. “Have we become too complacent, just because we haven’t seen this threat in our lives for so long? Just the threat of a spark of it would be revolutionary, in terms of how we price stocks and bonds.”

No one, of course, wants to see a worst-case scenario pan out – but if it does, expect to see inflation-linked bonds back on every menu.