Guide to Inflation -Linked Bonds June 2013

Guide to Inflation -Linked Bonds June 2013 This communication is for investment professionals only and should not be distributed to or relied upon by retail clients. Guide to Inflation-Linked Bonds 1

Contents 3 About Standard Life Investments 5 Some Key Concepts 5 Who Issues Inflation-Linked Bonds? 6 Who Invests in Inflation-Linked Bonds? 7 The Benefits of Inflation-Linked Investing 8 A Wide Opportunity Set 10 Managing Currency Risk in a Global Inflation Portfolio 11 A Brief History of Inflation-Linked Markets 12 The Role of Inflation Swaps 13 Key Global Inflation Indices 14 Contact Details 2 Guide to Inflation-Linked Bonds

About Standard Life Investments Standard Life Investments is a leading asset manager with an expanding global reach. Our wide range of investment solutions is backed by our distinctive Focus on Change investment philosophy, disciplined risk management and shared commitment to a culture of investment excellence. As active managers, we place significant emphasis on rigorous research and a strong collaborative ethos. We constantly think ahead and strive to anticipate change before it happens, ensuring that our clients can look to the future with confidence. As at 31 December 2012, Standard Life Investments managed 167.7 billion on behalf of clients worldwide. Our investment capabilities span equities, fixed income, real estate, private equity, multi-asset solutions, fund-of-funds and absolute return strategies. Headquartered in Edinburgh, Standard Life Investments employs more than 1,000 talented professionals. We maintain offices in a number of locations around the world including Boston, Hong Kong, London, Beijing, Montreal, Sydney, Dublin, Paris and Seoul. In addition, we have close relationships with leading domestic players in Asia, including HDFC Asset Management in India and Sumitomo Mitsui Trust Bank in Japan. Our parent, Standard Life plc, was established in 1825. A leading provider of long-term savings and investments, Standard Life floated on the London Stock Exchange in 2006 and is now a FTSE 100-listed company. Standard Life Investments was launched as a separate company in 1998 and has quickly established a reputation for innovation in pursuit of our clients investment objectives. Our investors rank among some of the world s most sophisticated and high-profile institutions. They include corporate pension plans, banks, mutual funds, insurance companies, fund-of-fund managers, endowments, foundations, charities, official institutions, sovereign wealth funds and government authorities. Guide to Inflation-Linked Bonds 3

Some Key Concepts The features of an inflation-linked bond An inflation-linked bond is similar to a nominal bond such as a Treasury bond. The only difference is that both its principal (the final payment at maturity) and its coupon (the interest rate paid during the life of the bond) are linked to an inflation index. This means that the investor receives the real (i.e. adjusted for inflation) face value of the bond at maturity, and the real value of the interest rate in the meantime. For example, if the annual coupon of a nominal bond was 5% and the underlying principal of this bond was 100, the annual coupon payment would be 5. In the case of an inflation-linked bond, if the inflation index increased by 75% over the life of the bond, the principal of the bond would increase to 100 x 175% = 175. The nominal coupon rate would rise in line with the price index over the life of the bond, and in this instance would be 8.75% (but still 5% in real terms) at maturity. Real yields Instead of focusing on nominal yields, investors in inflation-linked bonds are interested in real yields, which measure a bond s yield adjusted for inflation. This measure is important because inflation erodes the real value of investment returns on nominal bonds, and consequently reduces an investor s spending power in the future. It is also important to investors whose liabilities are impacted by inflation, as investors will seek to retain real spending power for the future. In fundamental economic terms, real yields can be interpreted as the price of economic capital for example, the price that businesses have to pay to invest in new plant and machinery. In boom times, this price rises with the demand for that capital, and therefore so do real yields. Conversely, in times of weakness, real yields fall as demand for capital falls. Nominal yields The nominal bond yield can be deconstructed using what is known as the Fisher equation. This breaks down nominal yields into three components: inflation expectations, a required real yield that investors demand over and above those inflation expectations, and a risk premium. This last factor, which represents the price investors are prepared to pay for a guaranteed real return, is notoriously difficult to calculate, and many an academic has failed to quantify it. For this reason, the market convention is to include risk premium within inflation expectations, resulting in the following simplified formula: Where: n = r = i = n = r + i yield on a nominal bond real yield on an IL bond of the same term maturity inflation expectations This equation results in one of the most important concepts for investors. The inflation expectations element of the formula represents the expected average level of growth in the price level over the life of a nominal bond and an inflation-linked bond of similar maturities. By extension, if the market is correct about these expectations, then in order for the equation to remain in equilibrium, the overall returns on the two bonds must be identical. This is known as the breakeven rate. If inflation is higher than what is priced in over the life of the bonds, the inflation-linked bond will give a higher return; if lower, the nominal bond will perform better. So, investors who wish to take a view on the path of inflation have a choice. If they believe that inflation will be higher than the level priced in by the market, they will sell nominal bonds and buy inflation-linked. If lower, they will do the opposite. If the market is right, the investors will breakeven. However, this is not just a hold-to-maturity strategy, as a breakeven rate priced by the market represents the expected average rate of inflation over the life of the bonds. Inflation expectations vary with economic conditions and so by varying the weightings of nominal and inflation-linked bonds in the portfolio, investors can take views on movements in those expectations. 4 Guide to Inflation-Linked Bonds

Who Issues Inflation-Linked Bonds? The primary issuers of inflation-linked bonds are governments. All of the G7 governments, and many others, now use the asset class as part of their borrowing programme. The reasons behind this are manifold, but it is done at least in part to cheapen the cost of funding. Governments expect to save the risk premium, by guaranteeing investors a real return. Investors are willing to pay more for this surety. Issuing inflation-linked bonds can be shown to smooth the cashflows of a government. A good deal of governments incomes are at least partly linked to inflation. Sales, value-added taxes and excise duties are prime examples. By matching the mix of income and payments, a government can reduce the volatility of its cashflows and, in theory at least, needs to adjust its tax rates less frequently. Inflation-linked bonds provide advantages to governments and central banks by demonstrating a market-driven, observable, measure of inflation expectations. On occasion, this can be distorted by institutional factors, but implied inflation expectations are a useful tool for policymakers. In some instances, issuing in the inflationlinked market has been used as a demonstration of a government s inflationfighting credentials. For example, the UK launched its inflation-linked market in the early 1980s at a time of high inflation and by taking on the inflation risk of its debt, it was demonstrating its determination to bring inflation under control. Many governments, for example some in South America, have found that when their inflation rates were persistently high, inflation-linked bonds were the only bonds that investors would buy. Issuance of inflation-linked bonds can also be seen as a means of reaching out to the widest range of investors possible, while also diversifying the risk of a government. In many ways, a government can be seen as a fund manager with the assets and liabilities column headings swapped over. Diversifying assets is every bit as important as diversifying liabilities. Non-government issuers are fairly rare outside the UK and are dominated by semi-government and agency issuers such as KfW, EIB and New South Wales Treasury Corporation. In the UK, a number of utility companies, whose pricing structures are statutorily linked to the Retail Price Index, have issued inflation-linked bonds. There are also a number of Private Finance Initiative bonds (PFI is a scheme to encourage government sponsored infrastructure spend without affecting the government s balance sheet), which were used to finance the building of schools and hospitals, and similarly had inflation-linked cashflows. Outside the UK, inflation markets are almost exclusively government and semi-government issued. Guide to Inflation-Linked Bonds 5

Who Invests in Inflation-Linked Bonds? Typical investor profile Inflation-linked bonds appeal to a wide and growing range of investors. Clearly, the ability to match inflation-linked liabilities is the prime reason to invest. If investors real liabilities are concrete, the only way to guarantee a cashflow in real terms at that point is to buy an inflationlinked bond that matures at the same time as the liability. Plenty of other real assets exist, such as equities, property and commodities, but they do not constitute an inflation hedge. They are far more volatile than the price level and may actually deliver a loss in real terms at the appointed time. A mixture of real assets will usually be a more efficient portfolio than a single asset and inflation-linked bonds tend to be poorly correlated with riskier real assets, so there is considerable diversification advantage to be had from adding inflation-linked bonds to the portfolio. Investors with a portfolio of fixed real terms liabilities may buy a matching portfolio of inflation-linked bonds. The portfolio can be designed to closely match the liability profile. However, many more investors opt for a less rigid match, but look at the appropriateness of the mix of their assets relative to liabilities. This tends to result in investments in actively managed, benchmark-driven portfolios of inflation-linked bonds. The most prominent among these investors are pension funds. They, by definition, have an extensive book of real liabilities, which they must meet at the appropriate time. An immature pension fund, where most of the liabilities are a long way in the future, can afford to take a riskier view, holding a more volatile range of real assets. As the fund matures, the risk appetite of the fund falls and the need for closer liability matching grows. This applies both to an individual s pension investment fund and to company or institutional wholesale funds. So as a fund matures, weightings in equities and property tend to fall in favour of inflation-linked exposure. Charities, endowments and foundations are also major investors in inflation-linked assets, looking to preserve capital without undue volatility. These investors also frequently have inflation-linked payment schedules to their beneficiaries, which makes inflation-linked investments all the more suitable. 6 Guide to Inflation-Linked Bonds

The Benefits of Inflation-Linked Investing In addition to the liability matching benefits we have just discussed, inflation-linked bonds play a much wider role in both the bond portfolio, and the total portfolio of assets. Bond holders who expect inflation expectations to rise should increase their holdings of inflationlinked bonds, as these will outperform nominal bonds if this occurs. Inflation-linked bonds are also less volatile than nominal bonds, as they respond to movements in real yields, not nominal yields. This results in a smoothing of returns to investors. More importantly though, inflation-linked portfolios, and particularly global ones, offer significant levels of diversification within the bond portfolio, as they have a relatively low correlation with other bond asset classes. Within the wider portfolio, those correlations are even lower, meaning that a global inflation-linked portfolio is an excellent diversifier, improving risk and return characteristics of the overall portfolio and pushing the investor closer to his or her efficient frontier. Guide to Inflation-Linked Bonds 7

A Wide Opportunity Set While the US remains the largest issuer of inflation-linked bonds, investing in global inflation-linked bonds offers a broader opportunity set than domestic portfolios, in addition to giving access to the global liquidity pool. The chart below is a distribution by size and maturity of bonds in the Barclays Global Inflation-Linked Index, showing the depth of the opportunity set available. Liquidity is generally good across the major inflation-linked issuers. Access to derivatives, while not required, widens the opportunity set yet further. In addition to the reduction in risk brought about by reducing exposure to unexpected changes in price levels by investing in an inflation-linked portfolio, moving from a domestic portfolio to a global portfolio reduces the risk further still, as no one country will determine the success or failure of your investment portfolio. In addition, a global portfolio will expand the opportunity set beyond the purely domestic market. Barclays Global Inflation-Linked Index - Distribution by size and maturity 50,000 40,000 Market Value in US$ (000s) 30,000 20,000 10,000 0 Jan-13 Jul-18 Jan-24 Jul-29 Dec-34 Jun-40 Dec-45 May-51 Nov-56 May-62 US Sweden Japan UK France Germany Canada Australia Source Barclays Capital, Barclays Global Inflation-Linked Index as at 30/04/2013. 8 Guide to Inflation-Linked Bonds

Reducing risks The chart below suggests very strongly that a portfolio of hedged global inflation-linked bonds is much more efficient than a simple domestic one, displaying significantly better risk-return characteristics. Similar results are generated against other bond asset classes and even greater diversification benefits are shown against asset classes in the wider portfolio. Efficient Frontier: World Govt Inflation-Linked All Maturities hedged vs FTSE British Govt Index-Linked All Maturities 7.40% 100% World Govt Inflation-Linked All Maturities Hedge 7.30% Minimum Risk Portfolio Best Risk Adjusted Return 7.20% 7.10% Return % 7.00% 6.90% 6.80% 6.70% 6.60% 100% FTSE I/L Gilt 6.50% 5.00% 5.20% 5.40% 5.60% 5.80% 6.00% 6.20% 6.40% 6.60% 6.80% Risk Source: Datastream and Barclays Capital: 31/12/1999-31/01/2013 Active versus passive investment We believe that the inflation-linked bond markets are inefficient and this creates an opportunity for active investment managers to outperform those that adopt a passive strategy. Because inflation-linked bonds represent a relatively small proportion of the global bond market, there is relatively limited research undertaken. Markets are localised and different markets are affected by different drivers. Adopting a passive strategy commits investors to abide by whatever the rules of the passive benchmark are, however bad. For example, an issuing country may underperform very substantially before being ejected from a benchmark index, damaging returns to passive investors. Active investors can anticipate such changes and create outperformance. This was the case when Greek inflation-linked bonds were ejected from the benchmark indices at the end of 2009. Passive investors will have been forced to sell at the end of the year when Greece dropped out of the benchmark. Active investors had the ability to reduce their exposure well in advance of this. Passive investing ensures that investors will fall into every pitfall along the way, whereas active investing allows the manager to help investors to avoid them. Guide to Inflation-Linked Bonds 9

Managing Currency Risk in a Global Inflation Portfolio Holding a global portfolio of course introduces exposure to the inflation rates of other countries and therefore a mismatch in returns. However, in a diversified global portfolio, so long as the currency exposure is hedged back to the domestic currency, the mismatch should be small over time. This relies on the concept that countries with higher inflation tend to have higher interest rates. This will mean that over the cycle, the carry on the foreign exchange hedge will offset the inflation mismatch. For example, an investor in a higher inflation, higher interest rate economy buys inflation-linked bonds in a lower inflation, lower interest rate economy. The bonds will provide insufficient uplift to match his domestic inflation but the interest rate differential will mean there is a positive carry on the foreign exchange hedge and these two should, over the medium term, net out. These relationships are not perfect and do not work instantaneously but a well diversified, hedged global portfolio of inflation-linked bonds should, over the medium term, be an effective domestic inflation-linked asset. 10 Guide to Inflation-Linked Bonds

A Brief History of Inflation-Linked Markets A global market in government inflation-linked bonds has only really existed since around the turn of the millennium. The UK was the first major issuer in 1981 and for some time it was a small corner of the world markets, present in just the UK, Canada and Australia. When the US launched its Treasury Inflation Protected Securities (TIPS) programme in 1997, the global market began to emerge. Euro-zone issuers followed, with France issuing bonds indexed both to French inflation (OATi) and Euro-zone inflation (OATei), and Italy, Greece and eventually Germany following in Eurozone-linked bonds. Japan completed the list of G7 issuers in 2004, and Sweden is also a large enough issuer to gain entry to market benchmark indices. The chart below shows the growth in the market value over time, showing that recent years have seen a massive increase in both supply and demand. The TIPS market has, unsurprisingly, surpassed all others in terms of size, representing 48% of the Barclays Global Inflation-Linked Index. The Euro-zone has grown to nearly 16% of bonds outstanding. (Source: Barclays Capital as at 01/03/2013) Other issuers Many other countries issue inflation-linked bonds, but are too small a size or too poor a credit rating to enter mainstream indices. Many countries at one stage could only issue in inflation-linked bonds, as investors would not buy nominal assets of countries with weak currencies and persistent high inflation. Brazil is the prime example of this and represents a large proportion of the emerging market inflation-linked index. Brazil has a long history in government inflation-linked bonds, its first issue dating back to 1964. It is the largest emerging market issuer with over $200 billion market value. Barclays Global Index Inflation-Linked Bonds Market Value ($bn) 2,500 2,000 1,500 1,000 500 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 US UK Sweden Australia Canada Japan France Germany Source: Barclays Capital. Data as at 1/03/2013. Guide to Inflation-Linked Bonds 11

The Role of Inflation Swaps As the size and sophistication of the global inflation market has expanded, a range of inflation derivative products has arrived to broaden the opportunity set further. The market for inflation swaps offers investors an alternative means of expressing their views on inflation. In each region, the inflation swap market uses the index to which domestic bond markets are linked. The most common structure of inflation swap traded is a zero coupon swap, where there is just one cashflow in each direction at maturity. In the example below, Party B pays a fixed amount, agreed at inception, and receives an amount linked to the growth in the relevant inflation index over the life of the swap. Therefore, if the price level rises by more than the fixed amount, party B makes a profit on the swap. The value of the swap at any given point in its life is determined by movements in inflation expectations since the inception of the trade. Role of inflation swaps Inflation Party A Party B Fixed Rate There are active inflation swap markets in the UK, US, Euro-zone, France, Australia and Japan. There are also less developed markets in Sweden and Canada but activity is very light. The inflation swap market and inflation-linked bond markets often interact via asset swap activity (whereby an investor can pay inflationlinked bond cashflows to a counterparty in exchange for LIBOR flows). The more active swap markets also have their own liquidity. Supply tends to come from corporate bond issuance, structured medium-term notes or retail savings products linked to inflation. Demand comes from pension funds (especially in the UK and a growing theme in Europe), real money and leveraged investors. The zero coupon nature of inflation swaps makes it an efficient way of implementing a view or hedging an exposure on a particular part of the curve without worrying about any cashflows prior to maturity that can be an issue when using bonds. Inflation swaps are now used by a wide variety of investors, for matching and hedging purposes, as well as in conjunction with bond markets to create more efficient portfolios. It should be noted that a long-term inflation swap does not guarantee a cashflow; if the counterparty ceases to exist, so does the swap. Swaps may be collateralised (typically daily) such that the current market value of a swap is protected but the actual payout should not be seen as equivalent in risk to a government bond. 12 Guide to Inflation-Linked Bonds

Key Global Inflation Indices Major issuers and their corresponding indices are shown in the table below. Key global inflation indices Country Issue Issuer Inflation index United States Treasury Inflation- Protected Securities (TIPS) US Treasury US Consumer Price Index (NSA) United Kingdom Inflation-linked Gilt UK Debt Management Office Retail Price Index Japan JGBi Ministry of Finance Japan CPI Germany Bund index and BO index Bundesrepublik Deutschland Finanzagentur EU HICP ex Tobacco France OATi and OATei Agence France Tresor France CPI ex-tobacco (OATi), EU HICP (OATei) Canada Real Return Bond Bank of Canada Canada All-items CPI Australia Capital Indexed Bonds Department of the Treasury (Australia) ACPI Sweden Index-linked treasury bonds Swedish National Debt Office Swedish CPI Italy BTP i Department of the Treasury EU HICP ex Tobacco Guide to Inflation-Linked Bonds 13

Contact Details For further information, please speak to your usual contact at Standard Life Investments, or visit our website. Visit us online standardlifeinvestments.com 14 Guide to Inflation-Linked Bonds

standardlifeinvestments.com This material is for informational purposes only. This should not be relied upon as a forecast, research or investment advice. It does not constitute an offer, or solicitation of an offer, to sell or buy any securities or an endorsement with respect to any investment vehicle. The opinions expressed are those of Standard Life Investments and are subject to change at any time due to changes in market or economic conditions. Standard Life Investments Limited is registered in Scotland (SC123321) at 1 George Street, Edinburgh EH2 2LL. Standard Life Investments Limited is authorised and regulated by the Financial Conduct Authority. Calls may be monitored and/or recorded to protect both you and us and help with our training. www.standardlifeinvestments.com 2013 Standard Life, images reproduced under licence 16 Guide to Inflation-Linked Bonds INVBBRO_12_0595_An_Investors_Guide_To_Inflation_Linked_Bonds_TCM 0513