Learn to Love the Linker

Transcription

1 Learn to Love the Linker A Guide to Index-Linked Gilts

2 Introduction Index-linked gilts or linkers as they are often referred, represent a core component of the UK debt market. For those who understand them, they offer unique investment characteristics that set them apart from more conventional debt instruments, while offering low correlation to other asset classes. Equally, however, for many they remain a complicated and poorly understood financial instrument, with income and principal values subject to constant inflation-adjustment. The aim of this Guide is to provide you with a solid, entry-level understanding of the UK index-linked gilt market how they work, their history, major issuers and the current market environment for these unique instruments. 2 AXA Fixed Income Learn to love the Linker

3 How they work Inflation reduces the return that conventional bonds can provide so much so, that high inflation levels can actually lead to negative bond returns in real terms. Inflation-linked bonds, also known inflationprotected bonds and, in the UK, as index-linked gilts (ILGs), provide investors with income that is protected from the value-eroding effects of inflation. Their principal value is similarly protected from future increases in inflation. From a functional perspective, ILGs work in much the same way as conventional government bonds. The investor receives a regular income via coupon payments until the bond matures, at which point the investor is repaid their initial investment principal in full. Impact of inflation Inflation is a well known investment risk and, as such, the coupon on a conventional bond contains some premium to compensate investors for future inflation risk. This premium that an issuer must offer in order to sell the bond, is effectively an estimation of expected inflation, over the life of the bond. However, the problem with conventional bonds offering fixed coupon payments is that the premium only reflects inflation expectations at the time of purchase. If the actual inflation rate turns out to be higher than this during the life of the bond, then inflation has an adverse effect on returns by eroding the purchasing power of the fixed rate coupons and principal. An investment in inflation-linked bonds provides a better hedge against inflation risk by offering the investor a lower coupon at the time of purchase, but at the same time linking future coupon returns to changes in realised inflation. RPI vs CPI In the UK, the Retail Price Index (RPI) is the official measure of the general level of inflation as reflected in the retail price of a basket of goods and services such as energy, food, petrol, mortgage payments, travel fares etc. It is against this measure of inflation that index-linked gilts are referenced. The reason that the RPI was chosen for this is that almost all inflation-linked liabilities for example defined benefit pensions were similarly linked to RPI inflation. The Consumer Price Index (CPI) is an alternative measure of inflation calculated on a consistent basis across European Union states. The methodology of calculation and coverage of the index differs from the RPI, in that it excludes housing costs and mortgage interest payments. CPI inflation tends to be the measure most quoted given that, since 2003, the Bank of England s key target in setting monetary policy is 2% CPI inflation. The rates of RPI and CPI inflation can diverge widely at times, particularly when interest rates are volatile. In fact, it has been estimated by the Bank of England that, over the long-term, RPI inflation will generally exceed CPI by around an average 0.75% p.a. Percentage (%) Consumer Price Index (CPI) (Annual % change, all items). 1.0 Retail Price Index (RPI) (Annual % change, all items). 0.0 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Source: Office of National Statistics, March 2015 AXA Fixed Income Learn to love the Linker 3

4 Real rate of return One of the most attractive features of ILGs is that they guarantee investors a real rate of return, that is, one that is adjusted to compensate for the effects of inflation. Index-linked coupons The difference between conventional bonds and ILGs is that the coupon payments and principal of the latter are indexed to inflation, thereby providing a yield that moves in line with inflation. The coupon paid on an inflation-linked gilt is based not on the par value of the bond, as for a conventional gilt, but on a principal value that is constantly moving in line with inflation, over time. The rate of accrual of the principal (and, therefore, of the coupon payments) is linked to movements in the Retail Price Index (RPI) measure of inflation. For conventional gilts, an assumption about expected inflation over the life of the bond is effectively built into the quoted coupon rate. ILGs, however, exclude such assumptions (and the associated premium paid), meaning ILG coupons are generally quoted at lower levels than those of conventional gilts. In practice, ILG investors receive semi-annual interest payments made up of the real coupon return, which is constant over the life of the bond, plus the inflation return, which reflects the movement in the RPI since the ILGs issue. Index-linked principal As mentioned already, the principal value of an ILG adjusts in line with changes in the RPI inflation index. Most modern inflation-linked bonds are capital indexed bonds (CIBs). CIBs are quoted in real terms and simply add on accrued inflation. The index accrual figure or index ratio as it is known in the UK, is applied to the principal value in order to, at any point, calculate an equivalent nominal value. An example in practice The following is a simplified example of how ILG returns remain protected from inflation, compared to the impact on conventional gilt returns. The key point to remember is that, for a conventional bond, the principal value is set at inception and redeems at this value at the bond s expiry. For an ILG, the principal is not fixed and actually grows in line with the inflation rate and the interest is calculated on the adjusted principal value. 10-year conventional gilt Principal value: 100 Interest coupon: 5% paid annually Annual inflation rate: 10% Each year investor receives 5 annual coupon payment ( 100 x 5%) and 100 principal repaid in 10th year. Annual nominal return = 5% Taking inflation into account: Annual real return = 5% (nominal return) - 10% (inflation) = -5% annual real return 10-year index-linked gilt Initial Principal value: 100 Interest coupon: 2.5% paid annually Annual inflation rate: 10% Year 1: Principal indexed to inflation rises to 110 ( 100 x 10%), investor receives 2.75 annual coupon payment ( 110 x 2.5%). Year 2: Principal indexed to inflation rises to , investor receives annual coupon payment ( x 2.5%) etc. Taking inflation into account: Annual nominal return = 12.5% (2.5% + 10% inflation uplift) Annual real return = 12.5% (nominal return) - 10% (inflation) = +2.5% annual real return This example highlights the way in which the ILG bond holder is assured at least the promised real return coupon rate, in this case, 2.5%. 4 AXA Fixed Income Learn to love the Linker

5 Breakeven rate The difference in yield between ILGs and conventional gilts of the same duration is called the breakeven rate. This is effectively the premium offered to investors to compensate for expected inflation. For example, if a 10-year conventional government bond yields 4.4%, and a 10 year ILG yields 2.4%, then the breakeven inflation rate is 2%. This is an important metric as it serves as a guide to market expectations of future inflation. Reliable indicators of inflation expectations are particularly important for central banks, such as the Bank of England, that are committed to maintaining price stability. In this regard, the presence of a mature, established inflation-linked bond market represents an important instrument from which to extract the market s inflation expectations. Breakeven rates present two main advantages as a gauge of market inflation expectations. First, they are the most immediate source of information on inflation expectations since they are available in real time, on every trading day. Secondly, as conventional and inflation-linked bonds are issued over a range of maturities, in principle, they provide information about inflation expectations at various time horizons, which is of considerable interest for central banks and private investors alike. Falling inflation environment Just as ILG principal and coupon payments are adjusted to reflect rising inflation, if prices are falling, then adjustments to the coupon and principal will similarly reflect this. In fact, brief periods of falling prices are common - for example, January inflation is often weaker December as a result of January sales. However, as long as the RPI is higher than when the last coupon was paid (every six months) adjustments to the principal and yield will also be positive, while the real coupon remains constant and unaffected. In 2009, the annual rate of RPI inflation did turn negative. This did not mean that the coupons were negative, but it did lead to coupons that were progressively lower than the previous coupon. It is in fact possible that the final principal amount could be lower than the nominal value of the ILG, but this would only happen in the extreme case where the level of the RPI was lower at bond maturity, than when the bonds was first issued (i.e. deflation over the entire life of the bond). Some issuers (e.g. France, USA) provide a deflation floor guarantee on the principal (but not on the coupons) ensuring that it will not fall below the nominal value, but this is not the case with UK ILGs. They are therefore likely to underperform conventional gilts in this exceptional environment. Index-linked gilt Yield protected against inflation. Capital value protected against inflation. Provides a real rate of return, immune from inflation. Lower coupon excludes inflation assumptions initially, but then linked to/ adjusted for inflation over time. Conventional gilt Does not protect yield against inflation. Does not protect capital against inflation. Provides generally higher nominal return, however, not protected from inflation. Higher coupon inflation assumption built at time of issue, but does not take into account inflation over bond life. AXA Fixed Income Learn to love the Linker 5

6 Indexation lag - 3 months, 8 months For all ILGs, there exists a lag between the publication of the RPI data, and the subsequent inflation indexation of the bond. In the UK, since their introduction in 1981, ILGs carried an eight-month indexation lag. The purpose of this lag was so that the amount of the next coupon (paid every six months) was known from the start of the interest accrual period. The extra two months account for the time taken to calculate and publish RPI data. However, in 2005 the UK Debt Management Office (DMO), the body responsible for issuing gilts, announced that all new ILGs would move to a three-month indexation lag design, similar to that of the Canadian market model, and considered to be more efficient. A growing number of ILGs have now been issued under this new framework, as depicted in the table below. Index-linked gilts in issue as at April 2015 Index-Linked Gilts (3-month Indexation Lag) Redemption Date First Issue Date Dividend Dates Total Amount in Issue ( mill nominal) Total Value including Index-linked Uplift ( mill) 1¼% Index-linked Treasury Gilt Nov-17 8-Feb May/Nov 11,846 15,625 0¼% 8 Index-linked Treasury Gilt Nov Aug May/Nov 8,183 8,371 1¼% 7 8 Index-linked Treasury Gilt Nov Jul May/Nov 15,743 19,561 0¼% 8 Index-linked Treasury Gilt Mar Oct Mar/Sep 14,344 15,120 1¼% Index-linked Treasury Gilt Nov Apr May/Nov 14,170 18,658 0¼% 8 Index-linked Treasury Gilt Mar Nov Mar/Sep 14,229 15,315 1¼% Index-linked Treasury Gilt Nov Oct May/Nov 12,760 15, ¼% Index-linked Treasury Gilt Mar May Mar/Sep 14,570 16,033 1¼% 8 Index-linked Treasury Gilt Nov Feb May/Nov 13,066 16, ¼% 8 Index-linked Treasury Gilt Mar Jan May/Sep 12,406 14,641 0¼% 5 8 Index-linked Treasury Gilt Nov Jul May/Nov 11,909 14,324 0¼% 8 Index-linked Treasury Gilt Mar Jul Mar/Sep 15,726 16,576 0¾% Index-linked Treasury Gilt Nov Nov May/Nov 11,687 14,374 0½% Index-linked Treasury Gilt Mar Sep Mar/Sep 12,221 14,634 0¼% Index-linked Treasury Gilt Mar Sep Mar/Sep 11,966 12,633 1¼% Index-linked Treasury Gilt Nov Sep May/Nov 10,169 13,520 0¼% 8 Index-linked Treasury Gilt Mar Jul Mar/Sep 8,000 7,989 0¾% 8 Index-linked Treasury Gilt Mar Oct Mar/Sep 12,480 13,523 0¼% 8 Index-linked Treasury Gilt Mar Sep Mar/Sep 9,750 9,978 Index-Linked Gilts (8-month Indexation Lag) Redemption Date First Issue Date Dividend Dates Total Amount in Issue ( mill nominal) Total Value including Index-linked Uplift ( mill) 2½% Index-linked Treasury Stock Jul Jan Jan/Jul 7,899 24,775 2½% Index-linked Treasury Stock Apr Oct Apr/Oct 6,579 20,300 2½% Index-linked Treasury Stock Jul Dec Jan/Jul 6,821 17,879 4½% Index-linked Treasury Stock Jul Jun Jan/Jul 4,841 9,174 2% Index-linked Treasury Stock Jan Jul Jan/Jul 9,084 13,396 6 AXA Fixed Income Learn to love the Linker

7 Who buys them? Broadly speaking, inflation-linked securities are highly attractive to investors who need to be certain that their investments will retain their real as opposed to nominal value over the medium to long term. These might include private investors saving for retirement and, most critically, institutional investors such as pension funds wishing to match future inflation-linked liabilities, like pension payments. In the UK, there may also be some advantage for tax payers in holding index-linked rather than conventional gilts because tax is payable only on the relatively low coupon payment, based on nominal value (i.e. they are exempt from income tax on the inflation protection element of the coupon, as well as capital gains tax). Who issues them? The main issuers of inflation-linked bonds are sovereign governments/central banks. Since the first issue in the UK in 1981, more and more countries have begun issuing inflation-linked bonds. An increasing number of companies are also issuing inflation-linked corporate debt. For issuers of inflation-linked bonds, a key attraction is that they allow the issuer to borrow more cheaply by issuing securities with lower nominal coupons. If the rate of inflation over the life of the bond turns out to undershoot expectations at the time of issue, then the issuer will have borrowed more cheaply still. Finally, it has also been suggested that issuance of inflation-linked bonds by governments sends an inflation-fighting message to the market, which in itself, may help in reducing nominal interest rates and, therefore, borrowing costs. For these reasons, issuing inflation-linked bonds is often seen as a win-win situation for both the issuer and the investor. The largest, most established inflation-linked bond markets include: Country Inflation-linked bond Issuer Inflation Index United States Treasury Inflation Protected Securities (TIPS) US Treasury US Consumer Price Index (CPI) United Kingdom Index-linked Gilt (ILG) UK Debt Management Office (DMO) Retail Price Index (RPI) France OATi OATei Agence France Trésor Agence France Trésor Bundesrepublik Deutschland Finanzagentur France CPI ex Tobacco EU HICP ex Tobacco Germany Bund Index EU HICP ex Tobacco Hong Kong ibond (domestic retail bonds) Hong Kong Government Composite Consumer Price Index Italy BTP i Department of the Treasury EU HICP ex Tobacco Canada Real Return Bond (RRB) Bank of Canada Canada All Items CPI Australia Capital Indexed Bonds (CAIN series) Department of the Treasury Weighted Average of Eight Capital Cities: All Groups Index Japan JGBi Ministry of Finance Japan CPI (nationwide, ex fresh food) Brazil Notas do Tesouro Nacional Série B Tesouro Nacional IPCA Sweden Index Linked Treasury Bond Swedish National Debt Office Swedish CPI AXA Fixed Income Learn to love the Linker 7

8 The development of inflation-linked bond markets Market beginnings One of the earliest bonds to have its principal and interest linked to the price of a basket of goods can be tracked back to an issue by the State of Massachusetts in However, the issuance of inflation-linked bonds throughout history has been sporadic and usually out of necessity, by countries experiencing volatile inflation. This backdrop changed in the 1980s when major developed economies began issuing indexed debt, not out of necessity, but as a deliberate policy choice. The UK is credited with launching the first inflation-linked bond of the modern era, when in 1981 the government issued a 1bn inflation-linked gilt available to institutional investors. Soon after, Australia (in 1985), Sweden (in 1994) and New Zealand (in 1995) all started issuing significant amounts of ILBs. In 1997, the market saw significant expansion when the US began issuing Treasury Inflation-Protected Securities (TIPS). More recently, France (in 1998), Greece and Italy (in 2003), Japan (in 2004) and Germany (in 2006), have also joined the market as well as Spain in Emerging markets were the earliest issuers of inflation-linked debt, including Brazil (1964), Chile (1966) and Venezuela (1967). Today, ILBs are now also issued by Mexico, Argentina, Peru, Uruguay, South Africa, Poland, Turkey, South Korea, Thailand and India. Indeed, while the benefits for investors, in the form of inflation-proof returns, were clear, academics such as John Maynard Keynes had long argued that a sovereign inflation-linked debt programme would benefit the sponsoring government also. For the issuing government, inflation-linked debt would result in cost savings because risk-averse investors would be willing to pay a premium for inflation protection. Recent market environment The global inflation-linked market has gone through a rapid period of growth over the past 20 years. The US TIPS market is now the largest inflation bond market. Considering its relatively recent start, the Eurozone market remains the second largest sovereign linker market, in terms of both volumes and turnover. Despite this growth, inflation-linked bonds still only account for a minor, although in most cases, rising, share of total government debt. Due to their key function for institutional investors, such as pension funds, and insurance companies, in managing long-term liability matching, the majority of ILBs issued tend to be concentrated at the longer end of the maturity spectrum. The global inflation-linked market has gone through a rapid period of growth over the past 20 years. One of the criticisms often levelled at ILBs is that, compared to conventional bonds, they represent a much smaller market, with less flexibility in terms of available spread of maturities. However, as the global ILB market continues to grow and evolve, so too do the criticisms become less relevant. 8 AXA Fixed Income Learn to love the Linker

9 Conclusion Index-linked gilts offer a real return to investors, over and above the prevailing level of inflation. This not only protects the purchasing power of investor returns, but offers more predictable longterm performance, relative to conventional bonds. Since ILGs provide more visible returns than conventional bonds, they are pivotal in terms of asset-liability matching investment strategies. ILGs also show a low historical correlation to equity and nominal bond markets, making them an attractive diversifying addition to a portfolio. And with more countries issuing inflation-linked bonds, there is increasing diversity within the asset class, a larger maturity spread and greater potential for returns. AXA Fixed Income Learn to love the Linker 9

10 Glossary Accrued interest Interest earned on a gilt since the last interest payment date, which is paid and received at the time of a transaction in addition to the clean price of the gilt. Auction Auctions are the main issuance method used to issue ILGs. They are open to IL gilt-edged market makers only (for competitive bids) and conducted on a uniform price basis, based on the lowest accepted price. This is in contrast to conventional gilt auctions where successful bidders are allotted gilts on a bid-price basis, paying the price they bid. There is also a limited facility for non-competitive bids. (See GEMMs). Break-even inflation rate Break-even inflation rate. This is the average annual inflation rate which, if realised, would equate the nominal yield on conventional gilt and that on an ILG of the same maturity, i.e. the rate at which (other things being equal) an investor would be indifferent between holding either type of gilt. Broker-dealers Members of the London Stock Exchange who may intermediate between customers and market-makers. They may also act as (matched) principals, transacting business with customers from their own gilt holdings. Clean price Quoted price of a gilt, which excludes accrued interest. For ILGs with a three month indexation lag, the quoted price is the real clean price. Competitive bid A bid for the gilt, which, if successful, would be filled at the price stated by a bidder in a conventional gilt auction. For index-linked auctions such a bid would be filled at the strike price of the auction. Consumer Price Index (CPI) An index published each month by Office for National Statistics, which measures the level of consumer goods and services in the UK. Coupon rate The yield paid by a fixed income security. It is simply just the annual coupon payments paid by the issuer relative to the bond s face or pour value. Deflation floor Feature available in certain international sovereign index-linked bonds (e.g. in the USA and France) but not UK index-linked gilts, by which the Issuer guarantees that the redemption payment will not be less than the original par value. Dirty price The total price payable on the purchase of a bond calculated as the clean price plus accrued interest for all gilts except ILGs with a three month indexation lag. In the case of the latter, the dirty price is calculated as the product of the real clean price and the relevant index ratio, plus the accrued interest. Debt Management Office (DMO) The United Kingdom Debt Management Office. Body responsible for issuing gilts. GEMMs and IL GEMMs Firms recognised by the DMO as gilt edged market makers (GEMMs) are primary dealers in conventional gilts. IL GEMMs are primary dealers for indexlinked gilts. Gilt A UK Government sterling denominated bond issued by HM Treasury. The term gilt (or gilt-edged) is a reference to the primary characteristic of gilts as an investment their security. Index-linked gilts (ILGs) ILGs are gilts where coupons and final redemption payment are related to movements in the Retail Price Index (RPI). There are two fundamental designs of ILGs those with an eight-month indexation lag launched prior to 2005 and those with a three month lag launched since Index ratio Feature applicable to three-month lag ILGs, which measures, on a daily basis, the growth in inflation since the gilt was issued. The DMO publishes daily index ratios for all three month lag index-linked gilts. Inflation-adjusted accrued interest Applicable to three month lag ILGs only. For a given day this is calculated by multiplying the real accrued interest amount by the index ratio for the day in question. 10 AXA Fixed Income Learn to love the Linker

11 Inflation-adjusted clean price Applicable to three-month lag ILGs only. For a given day this is calculated by multiplying the real clean price by the index ratio for the day in question. Inflation-adjusted dirty price Applicable to three-month lag ILGs only. For a given day this is calculated by adding the inflation-adjusted accrued interest to the inflation-adjusted clean price. Interest yield The interest rate based on the actual buying price. It is calculated by dividing the coupon by the clean price. Also referred to as the running yield or flat yield. This measure does not take into account the change in the capital value of the bond. Long maturity gilts UK government bonds with a residual maturity of over 15 years. Market value The value of an asset if it were traded in the market at its current price. Maturity date Date on which a bond is redeemed. Retail Price Index (RPI) An index published each month by Office for National Statistics, which measures the level of retail prices in the UK. Cash flows on all ILGs are linked to the RPI. Short maturity gilts UK government bonds with a residual maturity of up to seven years. Syndication A process whereby the DMO appoints a group of banks to manage the sale of a gilt on its behalf. This has become a more common method of issuance recently as the size of government issuance has grown. Uniform price auction Auction format used for the sale of ILGs at which all successful bidders pay the same clearing (or strike) price of the auction. Uplifted nominal value Applicable to ILGs: this is the nominal amount uplifted by the rate of inflation since the gilt was issued. Medium maturity gilts UK government bonds with a residual maturity of between seven and 15 years. Mini tender A method used in order to issue a small amount of gilts designed to supplement the existing auction timetable. Nominal amount/value The face or principal value of a gilt. Non-competitive bid A bid where no price is specified; such bids are allotted at the weighted average price of successful competitive bid prices, or for ILGs, the single strike price. Primary market The issuance of gilts by the DMO at auction. Real clean price Applicable to three month lag ILGs only. The quoted market price for a three month lag ILG, excluding any measure of the inflation uplift. Redemption date The date on which a dated gilt is redeemed. Also referred to as maturity date. AXA Fixed Income Learn to love the Linker 11

12 This document is for professional and retail investors. Circulation must be restricted accordingly. The views expressed do not constitute investment advice and do not necessarily represent the views of any company within the AXA Investment Managers Group and may be subject to change without notice. The value of investments and the income from them can fluctuate and investors may not get back the amount originally invested. Past performance is not a guide to future performance. Investments in newer markets and smaller companies offer the possibility of higher returns but may also involve a higher degree of risk. This document does not constitute an offer to sell or buy any AXA IM investment products or services. Information relating to investments is based on research and analysis undertaken or procured by AXA Investment Managers UK Ltd for its own purposes and may have been made available to other members of the AXA Investment Managers group of companies which, in turn, may have acted on it. While every care is taken over these comments, no responsibility is accepted for errors and omissions that may be contained therein. It is therefore not to be taken as a recommendation to enter into any investment transactions. Please note: all performance and other statistical data provided in this document is provided by AXA Investment Managers and is unaudited. As such, it may be subject to change without notice. Issued by AXA Investment Managers UK Ltd registered in England No The registered office address is 7 Newgate Street, London EC1A 7NX. AXA Investment Managers UK Ltd (119368) is authorised and regulated by the Financial Conduct Authority. Telephone calls may be recorded or monitored for quality assurance purposes. Design & Production: AXA IM London Corporate Communications /15