Inflation is coming, and with commodity prices and property valuations in decline, some investors are allocating to inflation-linked bonds, which are built to outperform once economic growth is hit and real yields fall. But ‘linkers’ carry illiquidity and volatility risks that can undermine their appeal. How should superannuation funds approach these assets? SIMON MUMME reports.

Robert Mead at PIMCO says the best protection against inflation is short-to-medium term government debt. The assets provide more attractive returns, and are less volatile, than what some say is a more intuitive defence commonly used by defined benefit and insurance funds: inflation-linked bonds (ILBs). Mead, head of portfolio management for PIMCO in Australia, points to the outperformance of medium-term government debt over ‘linkers’ in recent years, notably its return in 2008 of 11.2 per cent against the 8.5 per cent from ILBs.

In the year to date, medium-term government debt has garnered 0.3 per cent against the -2.7 per cent return from ILBs, and with less volatility. “Medium-term fixed income instruments remain very attractive for absolute and real returns,” he says. Past years have seen ILBs outperform nominal bonds, but the distress following the demise of Lehman Brothers in 2008 froze the
market for the instruments, resulting in negative returns and highlighting the ease with which this small market can become illiquid.

The episode also exposed the volatility of ILBs, which, due to their longer lifespans, generally have rollercoaster return profiles compared to nominal bonds. “ILBs are more
volatile because they have a longer duration as interest rates move around
irrespective of inflation,” Mead says. Taking these risks into account, PIMCO
opted to hedge its portfolios against inflation by investing in the intermediate
part of the yield curve for nominal bonds. Expected returns are slightly lower,
but the debt carries less volatility and illiquidity risk, and is offered at a
lower price.

The clear aim of the Reserve Bank of Australia (RBA) to keep
consumer price inflation between 2 to 3 per cent will also keep returns from
ILBs and medium-term nominal debt in the same range. “Given the very clear
mandate from the RBA, and the fact that the Australian Government will not
assume the amount of debt that the US
and UK have taken on, there
is no real incentive for inflation in Australia to pick up, and for the
government to inflate debt away.” Although ILBs offer guaranteed protection
against inflation, the determinant as to whether institutional investors should
buy them in the current environment is their face valuation. “For all
portfolios, we consider them as viable investments.

Even if you want an
inflation hedge, it comes down to what the hedge is costing you, and if it’s too
expensive, you shouldn’t buy it.” The $2.7 billion Electricity Industries Superannuation
Scheme (EISS) recently handed its portfolio of ILBs, previously managed internally
by associated manager FuturePlus, to ILB specialists Ardea Investment
Management, a Challenger-backed boutique. Michael Block, general manager of
investments at FuturePlus, says short-duration debt has outperformed because
fears about inflation were too strong, too soon.

“Government bonds have been
the best-performing asset in the past two years because there was an inflation shock
– it hasn’t been as bad as what it was thought to be,” Block says. He says ILBs
are an important part of a defensive portfolio for superannuation funds that
should be deployed alongside other fixed interest instruments. “Every fund,
directly or indirectly, is aiming to make a real return for pensioners.” This
return is typically between 4 and 5 per cent above inflation, Block observes,
and investors would do well to buy assets that can earn precisely this.

But it’s
easier said than done. “There has never been a fund that has been able to
create inflation plus 5 per cent over 20 years,” Block says. The commonly used
inflation hedges, such as commodities, shares and property, have not been
resistant to inflation throughout economic cycles. “They have much greater
capital risk. That’s the dilemma. I don’t believe that commodities are a good
inflation hedge because now we’re seeing their prices fall off a cliff. “In the
past, they’ve been correlated to inflation, but that doesn’t mean this will be
the case in the future.”

“What happens to them when growth is down?” Tamar
Hamlyn, principal at Ardea, asks. “They are good hedges for inflation provided
that growth is taking over.” And returns from cash, buoyed for much of 2007 and
2008 by high interest rates, can only ever be a “halfway reasonable” proxy for
an ILB because future returns can’t be locked in, Block says. “An exact way of
doing it is with ILBs. If you’re running a defined benefit or insurance fund,
they’re the perfect asset because they are ‘immunising’, meaning that assets
match liabilities.”

Block, formerly head of investments at the WorkCover NSW investment
fund, says the current ILB offering, providing inflation plus 2.5 per cent at a
decent price, is a good starting point for institutions aiming to lock in real returns
for the future. But the long-held consensus that balanced portfolios in a defined
contribution regime should allocate capital on a 70/30 split between equities
and bonds has prevented big allocations to ILBs. “Super won’t buy a lot of
ILBs, even though it should,” Block says.

The allure of the equity risk
premium, which historically outperforms ILBs but delivers periods of painful underperformance,
is dominant, pushing ILBs and other defensive assets to the periphery. There is
no clear winner among the inflation-hedging assets, and there is space for many
of them in a defensive portfolio, Block says. At EISS, ILBs account for a
quarter of the fixed income portfolio. When growth assets collapse, such a
small allocation to ILBs won’t keep the portfolio afloat. But a longer-term
focus could. “If super funds had thought a bit harder, and considered that they
might want to have longer-duration bonds because they better match their
liabilities, they wouldn’t have suffered as badly as they have in the past two
years. But they left their money in short-duration bonds.”

Ideally, funds
should split their bond allocation equally between ILBs and nominal bonds, says
Tim Unger, head of Watson Wyatt’s strategy team in Australia. But ILB markets here,
and perhaps abroad, are too illiquid for such a split to be implemented. “One
of the downsides is that there isn’t a lot of historical data for testing. So
the case for ILBs is more qualitative than quantitative,” Unger says. Up, up an d away … anytime now Talk of an impending surge in inflation or,
more threateningly, stagflation, has turned consultants’ attention towards
ILBs.

Unger says Watson Wyatt has always liked ‘linkers’ and the current environment
reinforces this view. “Environments that don’t favour risk assets, favour ILBs,”
he says. For now, however, inflation is a long-term risk and is not reflected
in the price of ILBs or inflation swaps. If economic growth is weak for the
medium to long-term, and interest rates stay near 3 per cent, ILBs would be a
worthwhile investment if offered at a good price. Peter Fisher, co-head of
BlackRock’s fixed income portfolio management group, says the fear of inflation
in premature.

“Inflation is coming, but later than you think. It’s about five
years out, not one year, because it is a very slow process.” Inflation is
usually the consequence of three forces – cheap credit, combined with aggregate
rising demand and little spare capacity in the economy – that are not evident
in the current environment. “Aggregate demand needs to rise continuously, and
that hasn’t happened, while unemployment is still rising. And we’ll know when credit conditions become easier for households
and businesses – when banks start lending,” Fisher says.

Indeed some think the risk
of short-term deflation is more pressing, as asset prices in developed
economies decline and headline inflation in the US falls. Watson Wyatt also sees
deflation as a likely shortterm risk. “There is still a lot of excess capacity
in developed markets, and the consumer sector is over-indebted,” Unger says.
PIMCO does not see stagflation as likely, since Australia’s indebtedness is not as deep
as that of other developed economies. “We don’t see inflation as being a
significant problem, but that said, to the extent that inflation protection becomes
cheap, we recommend that people buy it when it is cheap,” Mead says.

Unger says
the risk of inflation is distant, and therefore difficult to quantify. “It’s
not clear that if we have higher inflation, we’ll have higher real interest
rates. If central banks start to put up interest rates aggressively, higher
interest rates will hurt ILBs in the short-term.” Symon Parish, chief investment
officer with Russell Investments in Australia, says investors need to
remember that the price of an ILB reflects expectations of inflation, and not
movements in inflation itself.

“You only get upside to the extent that
inflation turns out worse (higher) than the consensus expectation at the time you
bought the bond.” But the outlooks for growth and inflation are very different
from the past two decades – in which the two have risen in tandem – and mark
ILBs as a viable asset, Ben Alexander, principal at Ardea, says.

Essentially,
they do well when growth gets hit hard and real yields fall. “Growth is at
risk, and in this environment, even if inflation tacks up, the RBA may be reluctant
to raise interest rates. ILBs will be one of the few assets to do well,” he
says. But their long duration makes them vulnerable to economic upswings that
occur during their lifespan. “The time to invest in ILBs is when you’re worried
about low growth and persistent inflation, or a very specific inflation scenario,
like stagflation.”

On the back of the Federal Government’s economic stimulus
spending, and in response to both national and state financing needs, the Australian
Office of Financial Management (AOFM) has begun increasing debt issues through
existing bond lines and is tipped to put out a new ILB, which will be its first
new issuance since 2003. Ardea is among the few domestic managers of ILBs.

Before
the Ardea team decamped and its subsequent deal with Aberdeen, Credit Suisse Asset Management
competed for mandates. State Street Global Advisors also does, but runs passive
funds only. The Queensland Investment Corporation, NAB and AMP run internal
portfolios of ILBs. It is difficult to trade the complex instruments, and the market
harbours numerous traps for unwary investors. “If you’re not in it regularly, you’ll
have trouble trading them and will probably be taken advantage of,” Alexander says.
“It is not very transparent; it’s easy to trade something at the wrong price,
or at the price that the sell-side puts on bonds that don’t trade often,”
Hamlyn adds.

 

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