“I’m French, Spanish, English, Danish. I’m not one, but many. I’m like Europe, I’m all that. I’m a real mess,” says Xavier in “L’Auberge Espagnole,” the French film about the economics graduate student who spends two semesters abroad in Barcelona as part of European Union’s Erasmus program in order to learn the language, which places him in the cultural melting pot in an apartment full of international students – an experience many European students can now identify with. As Xavier returns to Paris to his employer for who the period abroad was a prerequisite, he struggles with the bland office environment and with his own identity, namely the notion of a European identity: Is it one of unity, or just difference?
Similarly, the eurozone inflation-linked bond market is “in a real mess” as a result of the current crisis. The raison d'être for issuing and subsequently investing in inflation-linked bonds is now broken.
Inflation-linked bonds (ILBs) are the ultimate flight to quality instrument in a stagflationary world. As the debt-to-GDP ratio of a country with a fiat money regime increases, so does its willingness to inflate its way out of ballooning debt. Rising inflation expectations, in turn, are likely to boost demand and premium for inflation-linked bonds. However, in 2011, the Barclays Capital Euro Government ILB benchmark was down 0.94% against a positive 13.98% return in the U.S. Treasury Inflation Protected Securities (TIPS) Index.
The underperformance in the European ILB benchmark is in part due to widening credit spreads in Italian inflation-linked bonds. However, another significant contributor is the lack of a domestic investor base for most European ILBs. Because eurozone countries do not have control of the currency in which they issue their debt, some countries – namely non-core eurozone countries – are treated as if they have issued their debt in a foreign currency, which is compounded further by inflation-linked bonds indexed to foreign inflation. Italian ILBs are the poster child of this folly.
Traditionally, inflation linked-bonds provide policy makers with real-time measures of the market’s inflation expectations. Inflation breakeven is defined as the implied level of inflation based on ILB markets. It is the difference between real yields and nominal yields. However, a large portion of the eurozone ILB market hardly reflects, let alone trades on, inflation expectations in the current environment. Instead, they seem to be reflecting three components embedded in inflation break-evens: credit premium, liquidity premium and inflation risk premium (Figure 1 & 2).
Unless the eurozone countries collectively decide to inflate their way out of their sovereign debt problems through a large increase in the ECB balance sheet, Italian inflation-linked bonds are likely to keep trading like a more volatile and less liquid version of nominal Italian bonds. This makes the real yield and inflation breakeven rates on Italian inflation-linked bonds look “cheap” relative to their German counterparts.
Technical issues compound the problem
Trying to gauge the market’s inflation expectations has become highly complex for European investors. For one, breakeven inflation rates (BEI) on Italian ILBs have been highly volatile in recent months with substantial intra-day moves. For example, the BEI on Italian ILBs maturing in 2021 declined to 0% from 2% between 1 July 2012 and 28 November 2011, only to rebound and end 2011 at 1.18% (source, Bloomberg, 11 January 2012). This leaves the bond’s prevailing breakeven inflation level at 1.12%: Does that make it cheap relative to a breakeven inflation rate of 1.65% on a German ILB of comparable maturity? We need to analyze several factors to assess the cheapness. Firstly, assuming positive inflation accrual (in which case inflation-linked bond’s cashflows are more back-ended than nominal bonds) an ILB presents a higher credit risk. After adjusting for this risk and the relative illiquidity premium of ILBs and the maturity mis-match, we estimate the cheapness of the Italian ILB’s breakeven rate is at about 80 basis points. However, this valuation appears immaterial in the context of the extreme intra-day volatility Italian real yields have experienced in recent weeks. Secondly, there is the possibility of Italian ILBs could be excluded from the widely used Barclays Capital benchmark indices should Italy’s credit rating be downgraded to BBB by the ratings agencies. This would raise the risk of forced selling by passive index tracker investors. After all, Italian ILBs account for about 26% of the Barclays Euro Government Inflation-Linked Bond Index and about 6% of its Global ILB index. At BBB level, the Italian nominal bonds would remain included in the nominal bond indexes, further distorting the relative value of Italian ILBs vs. nominal bonds.
As if that was not messy enough, there is additional complexity around the legal documentation of inflation-linked bonds. The default clause refers to principal and accrued interest only in the case of Italy, omitting reference to accrued inflation on the principal. Thus, it is unclear whether the recovery rate will be applied only to the original principal or adjusted for inflation, as it should be.
Further, there is the question of which inflation price index euozone ILBs should be referenced to in the event of a eurozone break-up. In our view, if only one member country were to leave the union, such as Italy, the country’s inflation-linked bonds would likely remain linked to the eurozone inflation index, but Italy itself would be excluded from the eurozone inflation basket. Consequently, Italian ILBs would be unlikely to provide a hedge against domestic inflation arising from the likely devaluation of the Italian Lira. In effect, these bonds would be denominated in Lira yet referenced to German or core eurozone inflation.
Within this context, investing in eurozone ILBs is in essence a levered call on the issuer’s credit quality, especially in the context of Italian and to some extent French bonds. The prospect of dealing with the debt crisis via default rather than quantitative easing-driven inflation exacerbates the problem, as does the 100% issuance in a “foreign currency” in the absence of a fiscal union. Also, historical correlations of Eurozone Harmonized Consumer Price Index (HICP) with local country Consumer Price Index (CPI), which most real liabilities are indexed against, has limited use within the context of a possible eurozone break-up.
Essentially a European investor looking to secure consumption of real assets sometime in the future should think about alternative measures to protect their real purchasing power when hedging real liabilities, especially within pension funds or insurance schemes given their sizeable exposure to inflation risk.
So what are the alternatives?
There are several options here. First, it is worth considering inflation-linked bonds that are referenced to the domestic CPI of the issuing country. In the event an issuer goes back to its own currency, there would not be a discontinuation of the CPI and any currency devaluation-led inflation would be captured by that basket. In the eurozone, France is the only sovereign that issues inflation-linked bonds referenced to its domestic inflation index. In our view, these are the most suitable instruments for French investors seeking to hedge long-term inflation.
Inflation swaps on domestic inflation indexes is another alternative. There is a liquid market for these instruments in France, and while it is possible to trade them in German, Dutch, Spanish or Italian inflation indexes, their liquidity can be patchy due to the complexity in sourcing local inflation.
Another option is to consider inflation-linked bonds issued by non-eurozone countries that have their own currencies, working on the assumption that monetary inflationary paths employed by respective central banks will not only feed the asset prices outside the consumer price index, but that the sub-index of consumer goods will be a good representation of overall inflation. In line with our base case expectation for a low growth environment with currency devaluation, inflation-linked bonds should perform well as real rates remain compressed and stagflation raises inflation breakeven rates.
There is historical support for foreign inflation-linked bonds: First, eurozone inflation has significant positive historical correlation with U.S. and U.K. inflation (see table 1). Furthermore, the current level of expected long-term inflation in UK, US and eurozone countries is comparable. Thirty-year inflation expectations are at 2.24% in U.S. TIPS, 2.65% in U.K. index-linked gilts on an adjusted basis, and 2.18% in the eurozone with its less inflationary tendencies. Based on this, adding global inflation-linked bonds could be a way to preserve real wealth.
Two possible outcomes Let’s assess how European ILBs and Italian ILBs in particular would fare in two possible outcomes for the eurozone. The first scenario assumes that the European Central Bank (ECB) will expand its balance sheet through a quantitative easing program. Between the moral hazard of helping profligate countries and permitting financial Armageddon, the ECB might choose the least painful path in the form of quantitative easing. But in doing so, it raises the risk of overshooting its inflation target.
In this scenario, European inflation-linked bonds would richen quickly and potentially represent the safest way to protect real wealth as nominal rates become repressed, similar to what’s happening to U.S. Treasuries and U.K. Gilts. There would likely be a convergence in Italian, French and German 10-year real yields. Under this scenario, we estimate that Italian nominal bonds would gain 15% and their inflation-linked bonds could gain as much as 25% as eurozone inflation expectations rise well above the 2% ECB target and the current cheapness of inflation breakeven rates on Italian inflation-linked bonds quickly fade.
The second scenario could see Italy either default or restructure its debt but stay within the eurozone as the cost of rolling its debt becomes unbearable and growing discontent against austerity forces Italy’s hand. In this instance, Italian inflation-linked bonds might get a lower recovery rate than principal adjusted by cumulative past inflation accrual would imply, if breakeven rates are not already negative for the most recent ILB issues. In this instance, Europe would likely go down the path of a vicious deflationary circle.
Ultimately, for inflation-linked bonds to offer a potentially safe way to preserve real wealth they should not have any credit exposure. In fiat currency regimes they could be seen as the safest asset since a government has the option to print money rather than default on their debt, and inflation-linked bonds may protect against most of the currency devaluation over the long term. But European ILBs have a different profile. Italian ILBs as well as their nominal counterparts now mostly reflect credit risk and trade at a discount to compensate for the higher volatility and the positive correlation between inflation and credit risks. French inflation-linked bonds sit somewhere in between, but were France’s credit profile to deteriorate further their ILBs would start to resemble a levered version of French nominal bonds. French ILBs indexed to French inflation rather than eurozone HICP may at least offer some protection against the possibility of a eurozone breakup, currency devaluation and imported inflation.
"Later, much later, back in Paris, each harrowing ordeal will become an adventure. For some idiotic reason, your most horrific experiences are the stories you most love to tell”, says Xavier in L’Auberge Espagnole. Participants in the eurozone ILB market will have many more stories to tell over the next years no doubt as they put together a multi-pronged inflation hedging strategy.