By Padraig Floyd
Padraig Floyd asks whether it is sensible for UK investors to look to inflation-linked bonds issued by other nations to meet their liability-matching needs.
Interest rates have been at historic lows for an unprecedented period of time. But with expectations of them rising in some countries – definitely the US by the end of the year and perhaps, just perhaps in the UK, too – the gap between CPI and RPI is expected to widen. It is true that not all pension funds have tied themselves to CPI returns, but many have. Yet, with no UK-based instruments in existence, how can they protect themselves against rises in inflation? Of course, it could be done via derivatives, but these can be rather expensive and carry counterparty risk. Real assets such as property and infrastructure offer an indexlinked return or proxy for one might be considered, but then there are the concerns over illiquidity to overcome. One alternative might be to to look at CPI bonds issued by other nations. The reason any nation issues index-linked bonds is to generate confidence in their fiscal and monetary policies. If the government fails to control inflation, the investor gets greater returns. In the 1980s, they were used by Chile, Argentina, Brazil and Finland to raise longterm capital as they experienced highly volatile inflation. The UK and others used them after the war in the 1950s to lend greater credibility to disflationary policies. Australia, New Zealand and Sweden also did this in the 1980s. The amount of issuance has grown rapidly in the last few years and this has got people scratching their heads about how institutional investors might exploit overseas sources of inflation. LOOKING FURTHER AFIELD At JP Morgan Asset Management, a paper entitled The globalisation of inflation is to be published by Paul Sweeting and Alexandre Christie – European head and vice president respectively of the Strategy Group. It looks at the role of bonds in portfolios and ponders the opportunities in seeking inflation elsewhere. The components of CPI across the eurozone and Japan are very different, says Christie, but by charting the CPI indices, the correlations can be very high. “There were some very large differences which peaked in the 1980s,” says Christie, “but they converged in the late 1990s and early 2000s. “This convergence is important for longterm investors, but you must decide whether they are moving together or not.” The more correlated the inflation indices are, the better they will fulfill a proxy for UK CPI. Measurement is, however, very difficult, says Christie, as the common tool of co- movement is unwieldy and lacking response to dynamic components will give false indicators. His team has developed a measure they call co-integration which looks at the long-term co-movement over time and measures the connection between the CPI of one country and others. This has been used for the main developed economies and it shows strong correlation between the UK and the US between 1990 and 2013 with the brief exception of four months between 1999 and 2000 where it temporarily weakened.
“All they [advisers] talk about is safe havens in gilts and bonds and other assets in terms of their gilt-like qualities. I am fed up as a trustee of being told what we have to play with now is the same as pre-2008. This is not looking at the reality of today.”John Flynn