Investment Opportunities in Global Inflation-Protected Securities

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1 April 2010 Tony Norris Senior Portfolio Manager, First International Advisors Paolo L. Villasenor Product Manager Investment Opportunities in Global Inflation-Protected Securities Executive Summary Global Inflation-Protected Securities Market Global inflation-protected securities ( IPS ) are the fastest-growing sectors within global bond markets since 1997 and are now as large as several other important sectors. Advantages of Global IPS Investment The primary benefit to investing in IPS is to gain inflation protection. A global approach contrasted to investing in a single market provides additional benefits, including diversification and enhanced alpha potential. Diversification benefits are two-fold: diversifying exposures to real interest rate shocks and gaining the benefit from the low correlations between returns on global IPS and other assets in a broad asset allocation framework. In terms of enhanced alpha potential, global IPS provide a broader range of investment opportunities by virtue of the global opportunity set compared to a single-market strategy. Managers with significant active global fixed-income experience and proprietary, robust, time-tested models are best positioned to successfully identify investment opportunities and add value in global IPS strategies. Global IPS Within an Investment Portfolio Global bond indices do not include global IPS, so a specific allocation to global IPS can expand the opportunity set and complement an allocation to global bonds. Global Inflation-Protected Securities Market Global inflation-protected securities ( IPS ) represent a sizable fast-growing fixed-income market that offers investors protection from inflationary pressures. Many developed markets offer IPS in the form of bonds linked to a consumer price index. These securities can be classified as their own IPS asset class within each respective country, and IPS issuance in several countries dates back to the mid-1980s. As an asset class, IPS are the fastest-growing sectors within global bond markets, seeing a four-fold increase in market size relative to the global bond market since 1997 the year the global IPS index was introduced and also the year the United States began issuing TIPS in the form that we know them today (Figure 1a). This four-fold increase resulting in a 4 percent share of the global bond market corresponds to an absolute value that is larger than global high yield and global emerging sovereign bond markets. Thus, the size of the global IPS market is larger than some better-known global bond sectors but still small relative to some of the other global bond sectors, suggesting the IPS sector has room for future growth (Figure 1b). Figure 1a. Growth of Global Bond Sectors by Market Size Through December 2009 Market size in U.S.D. currency of global bond sectors Data as of December 31, 1997 Global Inflation-Protected Markets 1% Market Size in U.S.D. currency of global bond sectors Data as of December 31, 2009 Source: Merrill Lynch Global Bond Market Indices Global Sovereign 54% Global Corporate 15% Global Quasi Sovereign 9% Global Securitized (inc. MBS) 18% Global High Yield 2% Global Emerging Sovereign 1% Global Inflation-Protected Markets 4% Global Sovereign 45% Global Corporate 17% Global Quasi Sovereign 13% Global Securitized (inc. MBS) 18% Global High Yield 2% Global Emerging Sovereign 1%

2 Figure 1b. Market Size of Global Bond Sectors Market Size in U.S.$ (Millions) Date Global Inflation- Protected Markets Source: Merrill Lynch Global Bond Market Indices Global Sovereign Global Corporate Global Quasi Sovereign Global Securitized (Inc. MBS) Global High Yield Global Emerging Sovereign 12/30/ ,964 6,181,899 1,650, ,196 1,985, , ,090 12/31/2009 1,486,594 17,131,751 6,582,560 4,902,483 6,942, , ,649 In terms of annual growth rate, the global IPS sector exceeds the next fastest-growing global sector by almost 8 percent per annum (Figure 2). While the growth rate is not expected to be sustained over the long term, recent projections suggest continued shortterm growth in IPS issuance, and more countries are expected to initiate issuance of IPS in the near future. IPS issued by major markets present virtually no liquidity concerns, as major market IPS have been well established and regularly traded for many years. In countries where IPS are relatively new, it does not take a large investment to be overweight, but these smaller and newer IPS markets are taking measures to improve liquidity. In 2009, for example, Australia simplified the tax treatment of its IPS market and increased liquidity across the maturity range. As a whole, the global IPS sector is large relative to many other global bond sectors but still has room for future market growth. Furthermore, the IPS sector provides a more diverse universe from which to invest a key point to the alpha-generating opportunities that will be discussed later. Figure 2. Average Annual Growth Rate of Global Market Sectors Average annual percent growth rate (in local currency) of global market sectors (December 31, 1997, to December 31, 2009) 25% 20% 15% 10% 21.46% 8.84% 11.55% 13.51% 10.95% 13.04% 7.77% Advantages of Global IPS Investment Inflation protection is the main motivation for investing in IPS either in a single market or a global basis. However, there are additional advantages in a global approach to IPS that are compelling to investors, including diversification and enhanced alpha potential. Inflation Protection The primary intent for investing in IPS is to hedge against the future threat of long-term inflation. Inflation threats result from many sources and are present in many local economies as well as in the global economy as a whole. Traditional bonds are not inflation adjusted. Similarly, inflation can reduce the return on traditional equity investments as only a certain percentage of inflation may be passed on through equity returns. For example, equities did not provide good inflation protection during the stagflation of the 1970s. Although some real assets, such as gold and commodities, can provide inflation protection, their prices often swing due to changes in asset supply, investor risk appetite, or overall economic activity. Because adjustments to the principal owed on IPS are based on broad measures of local consumer prices rather than the price of a single or small number of real assets, we believe they are a better hedge against a local economy s overall inflation. Figure 3a. Long-Term Inflation Forecasts vs. Short-Term Forecasts Global break-even (long-term forecast inflation rate) and global forecasts for inflation 12 months hence Data as of December 31, 1997, to December 31, Global break even Global inflation forecast 5% % Global inflationprotected markets Global sovereign bond markets Global corporate bond markets Global quasi sovereign bond markets Global securitized bond markets (inc. MBS) Global high yield bond markets Global emerging sovereign bond markets /31/ /30/ /31/ /31/ /30/ /31/ /31/ /30/ /31/ /31/ /30/ /31/ /31/ /30/ /31/ /31/ /30/ /31/ /31/ /30/ /31/ /31/ /30/ /31/ /31/ /30/ /31/ /31/ /30/ /31/ /31/ /30/ /31/ /31/ /30/ /31/ /31/ /30/ /31/ /31/ /30/ /31/ /31/ /30/2009 Source: Merrill Lynch Global Bond Market Indices Sources: Consensus Economics, Merrill Lynch Global Bond Market Indices, & FIA Proprietary Systems 2

3 Figure 3b. Short-Term Inflation Expectations vs. Real Return of IPS Changes in short-term inflationary expectations vs. excess returns IPS less nominals /31/ /30/ /30/ /31/1998 Rolling 6-month return on IPS less nominals 03/31/ /30/ /30/ /31/ /31/ /30/ /30/ /31/ /31/ /30/ /30/ /31/ /31/ /30/ /30/ /31/ /31/ /30/ /30/ /31/ /31/ /30/ /30/ /31/ /31/2005 Average global inflation over last six months Sources: Consensus Economics, Merrill Lynch Global Bond Market Indices, & FIA Proprietary Systems 06/30/ /30/ /31/ /31/ /30/ /30/ /31/ /31/ /30/ /30/ /31/ /31/ /30/ /30/ /31/ /31/ /30/ /30/ /31/ Figure 4a. Correlation Between Inflation-Linked Index and Broad Asset Classes Correlation Matrix - 10 Years January December 2009 Merrill Lynch Global Government Inflation-Linked (U.S.D. Unhedged) S&P Russell Russell Barclays Capital U.S. Aggregate 0.68 Merrill Lynch High Yield Master II 0.41 Credit Suisse Leveraged Loan Index 0.27 MSCI EAFE Index 0.43 MSCI World Index 0.35 Merrill Lynch Global Broad Mkt 0.87 Merrill Lynch Global High Yield 0.46 Source: Zephyr Style Advisor To protect against the erosion of returns, IPS are primarily government-issued bonds where the principal on each bond is adjusted for inflation. The coupon payment is calculated by multiplying a fixed real yield by the inflation-adjusted principal value of the bond. If held to maturity, IPS can provide a domestic investor with a total return equal to actual inflation over the life of the bond plus the IPS real yield. Over shorter periods, the performance of IPS versus traditional bonds in local markets is directly correlated to inflation measures in those markets. Figures 3a and 3b feature charts that show the similar movement observed between long-term and short-term inflation forecasts and the real performance of IPS. Inflation expectations and IPS issues exhibit a direct relationship. Although IPS help hedge against inflation risk, some risks remain. In general, interest rates can be thought of as moving because of changes in inflation and because of changes in real (i.e., inflation-adjusted) interest rates. Unlike traditional bonds, IPS offer protection against interest rate movements caused by changes in inflation. However, prices of both traditional bonds and IPS will rise and fall with movements in real interest rates. In this sense, IPS incorporate duration risk. Diversification Because real interest rates in countries do not move lock-step, the risk associated with real interest rate movements can be diversified and thus reduced by moving from a singlecountry strategy to a global IPS strategy. As shown later, the volatility of returns from holding a currency-hedged global IPS portfolio has been significantly less than that from holding U.S. TIPS over three-, five-, seven-, and 10-year time horizons. Figure 4b. Correlation Between Inflation-Linked Index and Country-Specific Equity Indices Correlation Matrix - 10 Years January December 2009 Merrill Lynch Global Government Inflation-Linked (U.S.D. Unhedged) MSCI AC Asia 0.39 MSCI AC Europe 0.40 MSCI Pacific ex Japan 0.39 MSCI BRIC 0.38 MSCI USA 0.22 MSCI United Kingdom 0.37 MSCI France 0.37 MSCI Italy 0.43 MSCI Japan 0.36 MSCI Canada 0.38 MSCI Germany 0.29 MSCI Sweden 0.24 MSCI Australia 0.47 MSCI EU 0.39 Source: Zephyr Style Advisor Furthermore, global IPS exhibit low correlation compared to other traditional, long-only U.S., international, and global asset classes. Using major indices as a proxy, we observe a low correlation between the ML Global Government Inflation-Linked Index and 10 different asset classes on a 10-year trailing basis (Figure 4a). Correlation between the IPS index and equity indices in several geographical regions and countries (as represented by their corresponding MSCI indices in Figure 4b) is also low. As expected, the inflation-linked index is most correlated to other broad bond indices, such as the ML Global Broad Market and the Barclays U.S. Aggregate. But generally speaking, correlations 3

4 are observed to be much less than one, suggesting an opportunity for diversification. Adding an allocation to global IPS as a separate asset class further diversifies plans invested in traditional, longonly asset classes. The correlations shown in Figures 4a and 4b are based on returns from holding global IPS without hedging the currencies. When measured over a short time horizon, these currency fluctuations can increase the volatility of returns. However, currencies eventually need to move in a way that preserves each country s international competitiveness. This concept, known as purchasing power parity, implies that, over the long run, currency movements will reflect long-term differences in inflation trends across countries. Thus, to the extent that a burst in inflation in one country will eventually be reflected in a weakening currency, a strategy of holding global IPS on a currency-exposed basis is consistent with preserving a long-term hedge against inflation. Given the move to quantitative easing ( QE ) in many countries, primarily in countries where short-term interest rates are close to zero, the question of inflation risk comes to the fore. QE is the expansion of the money supply by actions of a country s reserve bank through a repurchase of outstanding government debt from banks and financial institutions in an effort to create a large supply of excess bank reserves. Though typically practiced when central banks conclude that even a zero interest rate may reflect a monetary policy that is too restrictive for current economic conditions, it can also create both downward pressures on a currency and concerns that central banks ultimately may keep monetary policy too easy for too long and thus result in eventual resumption of pricing pressures. To the extent that a shift to QE can lead to short-term currency pressures or to longterm inflation pressures, an unhedged global IPS strategy can help provide a hedge against these risks. Alpha Potential Although the universe of inflation-protected issues in a local market is limited, the global IPS universe provides additional alpha-generating opportunities that are more robust compared to single-market IPS. Active management of single-market IPS is limited to duration and yield curve management while managers of a global IPS portfolio can take advantage of the additional allocation opportunities offered to traditional global bond managers. Skillful active managers will seek to exploit inefficiencies and the larger opportunity set from multiple countries to outperform the indices. More broadly, observations suggest active global IPS managers have a stronger likelihood of outperforming global IPS benchmarks. This can be extrapolated from an analysis of global bond managers as a whole. Figure 5 shows the average level of alpha generated by the topquartile performing active managers in each universe compared to their individual benchmarks. As the level of risk increases from least risky (U.S. TIPS) to most risky (emerging debt), the average alpha generated by the top-quartile managers also increases. Alpha generated by global strategies is greater than all U.S. investment-grade strategies. It can then be projected that skillful active managers focused on global TIPS would generate greater alpha than those IPS investors focused only on single countries. Figure 5. Alpha Generated by the Top 25th Percentile of Active Managers in Several Bond Sectors Ranked by Perceived Risk (Lowest to Highest) The greater the opportunity set, the greater the potential alpha December 31, 1999, to December 31, P'Tile 'alpha' 3.57% 2.47% 1.54% 1.31% 1.11% 0.91% 0.41% 0.54% 0.34% US TIPS US Govt US Core US Core Plus Global Govt Global Agg US HY Global HY EMG Source: evestment Alliance Much of the potential alpha observed in global sectors results from country and currency exposure characteristics that apply to global IPS. When managers expand their universe from one country to many countries, the opportunity set increases. An active weighting of IPS results from overlaying the local inflation outlook onto the overall strength of that country s bond markets. A universe of global IPS has more investment opportunities than a universe limited to one IPS market, and as more countries begin to issue IPS, the opportunity set will further expand. Therefore, global IPS, while being a premium return sector, should also become one of the best opportunities for managers to add value. 4

5 Select Macroeconomic Outlook (Updated, March 2010) While it is difficult to perfectly forecast inflation, many economists would agree that the longer-term outlook for the global economy is less disinflationary than in the past. Although each individual national economy exhibits different inflation profiles, long-term inflation pressure certainly exists in large markets, including the U.K. and the U.S. For starters, we make the following fundamental observations in national economies. In the U.S., the government deficit is rising, monetary policy is excessively accommodative, and the economy has experienced a period of quantitative easing necessary to generate a level of growth and stabilization of the economy following the credit and financial industry problems of As a result, the U.S. is experiencing a small uptick in the growth outlook and some stabilization in property markets. While this has been advantageous in the near term, unemployment remains high and there is no observable appetite for the consumer to start borrowing and spending once again. The economic backdrop in the U.S. is likely to remain fragile for some time as the economy reduces its overall debt burden. A lingering fragility in the U.S. economy will likely prompt the Fed to continue to err on the side of preserving growth, allowing inflation to take the strain. These same issues are also observed in the U.K., Japan, and some peripheral areas of Europe. Furthermore, the global disinflationary effect we experienced through much of the period from 2000 to 2008 resulting from an overproducing China and a continually under-valued renminbi is likely to fade. China will be forced to deal with its own inflationary problems from higher import prices, and therefore, one can anticipate China will start to allow the currency to slowly appreciate. Figure 6. Inflation-Linked Real Yields in Select Global Markets Inflation-Linked Real Yields As of February 10, % 4.67% 4.61% 4.50% 4.00% 3.83% 3.50% 3.00% 2.93% 2.74% 2.89% 2.87% 2.50% 2.00% 1.56% 1.69% 1.48% 1.50% 1.09% 1.24% 1.00% 0.59% 0.81% 0.83% 0.50% 0.00% US UK France Italy Japan Canada Germany Sweden Mexico Greece South Africa Turkey Australia Poland Source: Merrill Lynch Global Bond Market Indices Investors in developed markets are specifically faced with a great opportunity to generate real yields and diversify their global investment through IPS. While real yields are seen to have converged in some major markets, the global universe suggests opportunity for diversification. Figure 6 shows a wide distribution of real yields observed in global markets. The different yields in each market represent different opportunities for global fixed-income investors. While it is true some convergence of real yields is observed in larger markets such as the U.S., Italy, and Japan, other countries such as Turkey, Poland, and New Zealand exhibit significantly different real yields. Although higher real yields may seem attractive, each yield comes with its unique country and market risks, so managers must also focus on the health of the local economies. An examination of yields in isolation would imply that Greece is a prime market for high global IPS returns, but in consideration of the Greek debt crisis of February and March 2010, the importance of an expansive local country analysis becomes more evident. New Zealand Finally, the growing demand for traditional energy sources, especially in emerging and BRIC countries, will continue to put upward pressure on oil and gas prices. We project that China alone may account for one-third of the global demand in This occurrence combined with government policies enacted to offset global warming will also result in further inflationary pressures. With this outlook, an increasing demand for IPS by long-term investors is envisaged. Because of the existence of inflation pressures in the longer term, a globally focused inflation-protection strategy will help hedge against the risk of greater inflation through a strategically positioned portfolio of IPS constructed to exploit the inefficiencies in global markets. Furthermore, an examination of each country s outstanding IPS as a percentage of the overall Global Inflation-Protected Bond Market (Figure 7) in conjunction with the Real Yields (Figure 6) shows that, while the U.S. and the U.K. account for the largest portions of the market, there are countries that offer better real yields. Countries such as Turkey, Poland, Australia, and New Zealand constitute a smaller percentage in the overall market but offer better real yields. In order to identify the best investment opportunities, the relative value of these countries higher real yields must be rigorously analyzed. 5

6 Figure 7. Country Weights of Global Inflation-Protected Bond Market Global inflation-protected bond market Size in U.S.$ 1,544,960 millions As of December 31, 2009 Investment Philosophy and Approach While active managers should approach global IPS investment in the way they approach broader global fixed-income investment, the distinguishing factor will be the inflation outlook that is overlaid onto each country s fundamental bond outlook. Active global bond managers can invest in IPS by creating portfolios that are weighted primarily based upon inflation expectations in each market. The first step might be to forecast the markets that are most likely to benefit from an inflationary environment. After each market is compared to the others to identify relative value from a country level, the portfolio team can select the specific issues that are best positioned to profit from the favorable inflationary environment in that country. This relative value is based on the issue s local environment and represents the biggest contrast to passive IPS investment. The active manager would look at the whole universe and weight the portfolio based upon the inflation analysis specifically performed on each country, whereas indexers would seek to match the benchmark weights with less flexibility in analyzing the country-specific characteristics. So while nominal yields may not differ too much in some larger countries, a relative value analysis might show that IPS in some countries are better poised to appreciate given the inflationary expectations of the country. United States 36.42% United Kingdom 22.00% France 14.10% Italy 8.45% Japan 4.30% Canada 2.81% Germany 2.79% Sweden 2.10% Mexico 2.11% Greece 1.14% South Africa 1.17% Turkey 1.59% Australia 0.69% Poland 0.23% New Zealand 0.11% Note: Total global market size shown is the sum of the individual countries Inflation Bond Index in the Merrill Lynch series of indices. Active currency management is an integral piece of the global investment framework, and skilled currency managers can greatly reduce return volatility in global bonds. Figure 8 shows the return and risk profiles of indices for unhedged global IPS, hedged global IPS, and U.S. TIPS as a proxy for single-market IPS. In each observed period, the hedged global IPS index exhibits lower volatility compared to both the unhedged global IPS index and the U.S. TIPS index. This reduced volatility is seemingly at the expense of returns, so one might conclude the costs of hedging currency outweigh the benefits of investing globally. While this might be the case for indexed global fixed income, in contrast, an active global manager experienced in currency management can reduce volatility and generate returns from currency management to compensate for the reduced volatility. In such cases, currency is not merely being hedged but instead is being actively managed as part of the global investment process. Active currency management becomes an additional source of potential alpha within an active global IPS strategy. Seasoned global bond managers that already allocate resources to covering IPS sectors in various developed markets are well suited to extend their efforts toward global IPS portfolios. Although the resultant global IPS investment approach is a natural extension of the investment team s approach toward global bonds, managers with extensive global experience featuring robust, time-tested models and active currency management are best positioned to successfully identify investment opportunities. Global IPS Within an Investment Portfolio From this discussion, pensions seeking inflation protection through single-market IPS such as U.S. TIPS or U.K. Linkers might be well suited to look toward global IPS for a portion of their overall allocation or risk budget. A global IPS strategy would still protect against local market inflation through the global portfolio s weight in the local market s IPS, but global IPS provide the previously discussed added benefits. Thus, global IPS should not fully replace a pension s single-market IPS allocation, but instead a reallocation of some single-market IPS assets to global IPS can diversify the portfolio and enhance returns. In addition to serving as a complement to single-market IPS, global IPS can also complement a plan s allocation to global bonds. Because IPS are not included in standard global bond indices such as the Merrill Lynch Global Broad Market Plus or the Barclays Global Aggregate, IPS weights in a global bond

7 Figure 8: Risk vs. Return for IPS Indices Source: Merrill Lynch Global Bond Market Indices & FIA Proprietary Systems strategy would be categorized as non-index. Therefore, even a small shift of global bond allocations to global IPS can serve to diversify the plan s holdings and enhance returns. A coresatellite approach could also be well served by allocating assets to indexed, broad-based global bonds as the core and using an active global IPS strategy as an alpha generator. Conclusion Global IPS not only protect against long-term inflation pressures but also add diversification to global bond allocations and provide enhanced alpha potential. IPS protect against a broad array of inflation sources not limited to core inflation. We believe that alpha potential is vast for experienced global bond managers who utilize robust models and analysis toward skillful and timely navigation of economic and inflationary expectations in numerous national markets. In contrast to focusing on just one market, global active managers benefit from larger opportunity sets in several countries and can generate alpha by selecting issues from markets that are best positioned to benefit from that market s specific inflation expectation. The perceived additional volatility from currency can be managed actively and may result in an additional source of alpha for these global bonds. Although the global IPS market is not a major asset class that consultants and plan sponsors currently follow, the growth and size of the market combined with the inherent benefits of inflation protection and alpha generation make global IPS worthy of a specific allocation within a portfolio. 7

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