Inflation Linked Bonds Correct Asset Mismatch
By: Margaret Isberg
Many of the asset classes that pension plans have traditionally used to hedge against rising inflation are not particularly reliable. Margaret Isberg, of PIMCO Canada Corp., examines using global inflation linked bonds to address this situation.
Aduration mismatch between the assets and liabilities of most pension plans was a significant contributor to the widespread underfunding we see today. But another mismatch of significant proportions is still being tolerated – namely, inflation risk. The majority of Canadian pension plans are fully or partially indexed, yet they invest an average of only 5.7 per cent in inflation sensitive assets according to a recent survey1.
Funds have traditionally looked to their large equity allocations as a hedge against inflation – not because equities do well when inflation is high or rising, because the opposite is normally true. Rather, equities offer higher expected returns, and it is presumed that over time, this equity risk premium will be sufficient to compensate for the adverse impact of inflation on liabilities. But with a secular turning point in global inflation probably at hand, and with many market forecasters warning of more modest stock returns in the future, plans would be well advised to begin addressing their inflation mismatch.
Many of the asset classes that pension plans have traditionally used to hedge against rising inflation, including real estate and commodities, are not particularly reliable, exhibiting rather lose correlations to inflation. The only truly dependable inflation-hedging asset is an inflationlinked bond (ILB) or real return bond (RRB), whose principal and coupons go up as consumer prices rise. Canadians wishing to invest in the sector face certain headwinds, but as we shall see, they can be overcome.
ILBs are a relatively new asset class. The modern market was launched in 1981, when the UK first issued index-linked gilts (government securities). Canada took an early lead with the creation of its Real Return Bond program in 1991 and most other developed countries followed suit. The market grew steadily through the end of the 1990s, despite a backdrop of falling inflation, which curbed investor interest in the sector. In the last couple of years, with inflation rates bottoming or rising across the globe, the ILB market has experienced explosive growth, more than doubling in size to US$600 billion. Volume in the ILB swaps and inflation derivatives markets is growing even faster (see Table 1).
Secular Inflection Point For Global Inflation
A critical impetus for increasing ILB exposure now is the outlook for global inflation. Inflation fell for most of the last two decades as monetary policy makers around the globe pursued preemptive tightening, fiscal policy, focused largely on shrinking or eliminating deficits. As well, deregulation freed many sectors from the shackles of government interference. These policies helped to pull global inflation down from more than 12 per cent in 1980 to under two per cent today2. But with the war of price stability essentially won, a sea change is upon us. Policy makers realize that deflation is more pernicious than inflation and now presents the greater risk. In response, most central bankers, particularly the U.S. Fed, have shifted to a preemptive easing strategy where somewhat higher inflation will be welcomed as an insurance policy against a deflationary spiral. And fiscal policy makers in many parts of the world have re-embraced old-fashioned Keynesian stimulus, as evidenced by growing deficits in the U.S., Europe, and Japan. Thus, odds are good that inflation is headed higher. While the regime of the 1980s and 1990s resulted in inflation that surprised markets on the downside, the new regime suggests that upside inflation surprises are more probable going forward.
The ILB market is likely to offer supportive supplydemand dynamics for the foreseeable future. Supply is expected to continue growing rapidly as governments around the globe issue inflation linked debt in an attempt to reduce their funding costs and broaden their investor base. Japan and Italy both recently issued ILBs for the first time; Germany and many other countries are expected to follow. While supply is rising, demand for inflation linked bonds should rise even faster, as aging populations increasingly shift their investment focus to preservation of purchasing power, and pension plans try to minimize their asset-liability mismatch. In short, the inflation linked bond market is becoming an increasingly important sector of the global capital markets.
Canadian Real Return Bonds
Due to certain structural limitations of the Canadian RRB market, a key question for Canadian pension plans becomes how to effectively invest in ILBs. Demand is outstripping supply in several markets around the globe and Canada is a case in point. Because the Federal government has been running primary budget surpluses for several years, total debt issuance has been low, causing Canadian RRBs to be chronically expensive compared to global alternatives. One way to gauge relative value between ILBs is to compare inflation risk premiums. By taking the break-even inflation rate of an ILB (the level of inflation needed to make the return on an ILB superior to a nominal bond) and deducting the consensus inflation forecast, you are essentially left with the premium investors are willing to pay to eliminate their inflation risk. With current RRB breakevens at a p p r o x i m a t e l y about 2.75 per cent, depending on maturity, the inflation risk premium in Canada is roughly 75 basis points. That is one of the highest premiums among global ILB markets, despite the fact that Canada’s inflation outlook is more sanguine and predictable – the result of a disciplined and transparent central bank, prudent fiscal policy, and a strong currency. Long US TIPs (Treasury Inflation Protected Securities), in contrast, have a current inflation risk premium of only 40 basis points, even though the U.S. has a more stimulative monetary policy, a huge fiscal deficit, and a weak currency.
The Canadian RRB market is also relatively illiquid, the result of many large institutions holding and not trading a significant portion of RRB issuance. And while most other ILB markets – including the U.S., Australia, France, Sweden, and the UK – have short, intermediate, and long dated issues, Canada’s four outstanding RRBs are all long, maturing in 2021 through 2036. That presents Canadian investors with structural constraints and also limits the potential value added from active management.
Global ILBs: A Substitute For RRBs
But Canadian pension plans need not despair because a portfolio that includes significant allocations to non-Canadian ILBs can be an effective surrogate for a Canadian-only portfolio. The correlation between Canadian inflation and that of other developed markets is high. This makes intuitive sense, as greater global economic integration tends to unleash similar forces on all countries. From 1969 through 2003, Canadian inflation had an average 0.83 correlation to the inflation rates of other major ILB issuers, as shown on Table 2.
Expected absolute returns from ILBs will typically be below the target rate of return for most plans, so using them to shrink the asset-liability mismatch will come at a cost. However, the potential alpha from an actively managed global inflation linked bond portfolio can mitigate that to some extent.
Real Return portfolios can exploit all traditional active management strategies, including managing duration, yield curve, and sector exposure. While the ILB market is predominantly a government market, including provincial/agency-type issuers, there are some corporate and infrastructure bonds also outstanding. Managers can take advantage of shifts in relative value between sectors as well as between ILBs and nominal bonds. And security selection can also be a source of value as ILB markets are young and often inefficient.
Adding global ILBs to the opportunity set can increase expected returns further. First and foremost, they enable Canadian investors to diversify away from a market that, as noted above, is often expensive. Second, global ILB valuations are not static, allowing active managers to exploit relative value differences among countries. Global positions, however, should be currency hedged to avoid introducing unwanted volatility. Because there is an active repo market for most globals, they can be bought on a forward basis, so need not use any of a plan’s precious foreign content allowance.
In addition to helping pension plans match their liabilities, inflation linked bonds can also be an effective hedge or diversifier for other pension assets. The majority of plans are heavily exposed to financial assets (stocks, bonds, and cash), which typically suffer with inflation, so ILBs are a nice compliment to a typical asset allocation.
A Perfect Storm?
It is common to blame today’s funding crisis on the ‘perfect storm’ which saw the simultaneous drop in both stock prices and interest rates. But ignoring basic financial principles by intentionally running a large duration mismatch was analogous to heading out to high seas without a life raft. When the storm hit in 2000, the consequences were entirely predictable. Eliminating mismatches by fully immunizing pension funds is difficult and costly to accomplish, but tolerating a perpetual mismatch of significant proportions can also be very costly, as many plans now realize. Betting that inflation will remain forever well-behaved is not a prudent course. Allocations to inflation-linked bonds are one of the most efficient ways to address the inflation mismatch present in most Canadian pension plans and a portfolio of global inflation linked bonds is an attractive way to implement this.
Margaret Isberg is president of PIMCO Canada Corp.
1. Benefits Canada Top 100 Pension Funds survey, for year ending December 31, 2003
2. Annual inflation rates of industrialized countries, IMF
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