For professional clients only LEARN TO LOVE THE LINKER INFLATION-LINKED BONDS IN DEPTH

For professional clients only LEARN TO LOVE THE LINKER INFLATION-LINKED BONDS IN DEPTH

CONTENTS Introduction 3 How do they work? 4 The development of inflation-linked bond markets 12 Conclusion 13

INTRODUCTION Index-linked bonds (ILBs) or linkers, as they are often referred to, represent a core component of the global debt market. For those who understand them, they offer unique investment characteristics that distinguish them from more conventional debt instruments, and tend to offer a low correlation of returns to other asset classes. The aim of this guide is to provide you with a solid, entrylevel understanding of the index-linked bond market how it works, its history, major issuers and the current market environment for these unique instruments. Equally, however, for many they remain a complicated and poorly understood financial instrument, with income and principal values subject to constant inflation adjustment. AXA INVESTMENT MANAGERS INFLATION-LINKED BONDS IN DEPTH 3

HOW DO THEY WORK? Inflation reduces the return that conventional bonds can provide by eroding the purchasing power of the bonds initial investment and coupons so much so, that high inflation levels can actually lead to negative bond returns in real terms. Inflation-linked bonds, also known as inflation-protected bonds, provide investors with income that is protected from the value-eroding effects of inflation. Their principal value is similarly protected from future increases in inflation. From a functional perspective, ILBs work in much the same way as conventional government bonds. The investor receives a regular income via coupon payments until the bond matures, at which point the investor is repaid their initial investment principal in full. However, the problem with conventional bonds offering fixed coupon payments is that the premium only reflects inflation expectations at the time of purchase. If the actual inflation rate turns out to be higher than this during the life of the bond, then inflation has an adverse effect on returns by eroding the purchasing power of the fixed rate coupons and principal. An investment in inflation-linked bonds provides a better protection against inflation risk by offering the investor a lower coupon at the time of purchase, but at the same time linking future coupon returns to changes in actual inflation. IMPACT OF INFLATION Inflation is a well-known investment risk and, as such, the coupon on a conventional bond is higher to compensate investors for future inflation risk. This higher payment that an issuer must offer in order to sell the bond, is effectively an estimation of expected inflation, over the life of the bond. 4 AXA INVESTMENT MANAGERS INFLATION-LINKED BONDS IN DEPTH

RPI VS. CPI While they aim to achieve the same thing, inflation-linked bonds go by a variety of names. And, they do not all track the same measure of inflation. In the UK, they are known as index-linked gilts and track the Retail Price Index (RPI) which is the official measure of the general level of inflation as reflected in the retail price of a basket of goods and services such as energy, food, petrol, mortgage payments, travel fares, etc. It is against this measure of inflation that index-linked gilts are referenced. The reason that the RPI was chosen for this is that almost all inflation-linked liabilities for example defined benefit pensions were similarly linked to RPI inflation. In Europe, index-linked bonds are based on the Harmonised Index of Consumer Prices (HICP), excluding tobacco, which is calculated on a consistent basis across European Union states. In this region The methodology of calculation and coverage of the index differs from the RPI, in that it excludes housing costs and mortgage interest payments. In the US, which makes up the largest portion of the global ILB market, the instruments are known as Treasury inflation-protected securities and track Consumer Price Inflation (CPI). The rates of RPI and CPI inflation can diverge widely at times, particularly when interest rates are volatile. In fact, the Bank of England has written that UK RPI inflation could exceed CPI (see graph below) by around 0.66% p.a. over the long term (although market participants expect a larger wedge of 0.80-1.00%). Percentage (%) 6.0 5.0 4.0 3.0 2.0 1.0 Consumer Price Index (CPI) (Annual % change, all items) 0.0 Retail Price Index (RPI) (Annual % change, all items) -0.1 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Source: Bank of England, 10 August 2016 AXA INVESTMENT MANAGERS INFLATION-LINKED BONDS IN DEPTH 5

HOW DO THEY WORK? REAL RATE OF RETURN One of the most attractive features of ILBs is that they guarantee investors a real rate of return, that is, one that is adjusted to compensate for the effects of inflation. INDEX-LINKED COUPONS The difference between conventional bonds and ILBs is that the coupon payments and principal of the latter are indexed to inflation, thereby providing a yield that moves in line with inflation. The coupon paid on an inflation-linked bond is based not on the par value (nominal value) of the bond, as for a conventional bond, but on a principal value that is constantly moving in line with inflation, over time. The rate of accrual of the principal (and, therefore, of the coupon payments) is linked to movements in the relevant measure of inflation. In practice, ILB investors can receive semi-annual or annual interest payments made up of the real coupon return, which is constant over the life of the bond, plus the inflation return which reflects the movement in inflation since the ILBs issue. INDEX-LINKED PRINCIPAL As mentioned already, the principal value of an ILB adjusts in line with changes in the inflation index. Most modern inflation-linked bonds are capital indexed bonds (CIBs). CIBs are quoted in real terms and simply add on accrued inflation. The index accrual figure or index ratio as it is known in certain regions like the UK, is applied to the principal value in order to, at any point, calculate an equivalent nominal value. For conventional bonds, an assumption about expected inflation over the life of the bond is effectively built into the quoted coupon rate. ILBs, however, exclude such assumptions (and the associated premium paid), meaning ILB coupons are generally quoted at lower levels than those of conventional bonds. 6 AXA INVESTMENT MANAGERS INFLATION-LINKED BONDS IN DEPTH

AN EXAMPLE IN PRACTICE The following is a simplified example of how ILB returns protect against inflation, compared to the impact on conventional bond returns. The key point to remember is that, for a conventional bond, the principal value is set at inception and redeems at this value at the bond s expiry. For an ILB, the principal is not fixed and actually grows in line with the inflation rate and the interest is calculated on the adjusted principal value. 10-YEAR CONVENTIONAL BOND Principal value: 100 Interest coupon: 5% paid annually Annual inflation rate: 10% Each year investor receives 5 annual coupon payment ( 100 x 5%) and 100 principal repaid in 10th year. Annual nominal return = 5% Taking inflation into account: Annual real return = 5% (nominal return) - 10% (inflation) = -5% annual real return 10-YEAR INDEX-LINKED BOND Initial principal value: 100 Interest coupon: 2.5% paid annually Annual inflation rate: 10% Year 1: Principal indexed to inflation rises to 110 ( 100 x 10%), investor receives 2.75 annual coupon payment ( 110 x 2.5%). Year 2: Principal indexed to inflation rises to 121.00, investor receives 3.025 annual coupon payment ( 121.00 x 2.5%), etc. Taking inflation into account: Annual nominal return = 12.5% (2.5% + 10% inflation uplift) Annual real return = 12.5% (nominal return) - 10% (inflation) = +2.5% annual real return This example highlights the way in which the ILB bond holder is assured at least the promised real return coupon rate, in this case, 2.5%. For illustrative purposes only. AXA INVESTMENT MANAGERS INFLATION-LINKED BONDS IN DEPTH 7

HOW DO THEY WORK? BREAKEVEN RATE The difference in yield between ILBs and conventional bonds of the same duration is called the breakeven rate. This is effectively the premium offered to investors to compensate for expected inflation. For example, if a 10-year conventional government bond yields 4.4%, and a 10-year ILB yields 2.4%, then the breakeven inflation rate is 2%. This is an important metric as it serves as a guide to market expectations of future inflation. Reliable indicators of inflation expectations are particularly important for central banks, such as the US Federal Reserve and the Bank of England, that are committed to maintaining price stability. In this regard, the presence of a mature, established inflation- linked bond market represents an important instrument from which to extract the market s inflation expectations. Breakeven rates present two main advantages as a gauge of market inflation expectations. First, they are the most immediate source of information on inflation expectations since they are available in real time, on every trading day. Second, as conventional and inflation-linked bonds are issued over a range of maturities, in principle, they provide information about inflation expectations at various time horizons which is of considerable interest to central banks and private investors alike. FALLING INFLATION ENVIRONMENT Just as ILB principal and coupon payments are adjusted to reflect rising inflation, if prices are falling, then adjustments to the coupon and principal will similarly reflect this. In fact, brief periods of falling prices are common. For example January inflation is often weaker than December as a result of January sales. However, as long as the inflation rate is higher than when the last coupon was paid (every six months or every year), adjustments to the principal and yield will also be positive, while the real coupon remains constant and unaffected. In 2009, for example, the annual rate of RPI inflation in the UK did turn negative. This did not mean that the coupons were negative, but it did lead to coupons that were progressively lower than the previous coupon. 8 AXA INVESTMENT MANAGERS INFLATION-LINKED BONDS IN DEPTH

It is in fact possible that the final principal amount could be lower than the nominal value of the ILB, but this would only happen in the extreme case where the level of the inflation rate was lower at bond maturity, than when the bonds were first issued (i.e. deflation over the entire life of the bond). Some issuers (e.g. France, USA) provide a deflation floor guarantee on the principal (but not on the coupons) ensuring that it will not fall below the nominal value, but this is not the case with UK ILGs. They are therefore likely to underperform conventional UK government bonds in this exceptional environment. INDEX-LINKED GILT Yield protected against inflation. Capital value protected against inflation. Provides a real rate of return, immune from inflation. Lower coupon excludes inflation assumptions initially, but then linked to/adjusted for inflation over time. CONVENTIONAL GILT Does not protect yield against inflation. Does not protect capital against inflation. Provides generally higher nominal return, however, not protected from inflation. Higher coupon inflation assumption built at time of issue, but does not take into account inflation over the bond s life. AXA INVESTMENT MANAGERS INFLATION-LINKED BONDS IN DEPTH 9

HOW DO THEY WORK? WHO BUYS THEM? Broadly speaking, inflation-linked securities can be attractive to investors who need to be certain that their investments will retain their real as opposed to nominal value over the medium to long term. These might include private investors saving for retirement and, most critically, institutional investors such as pension funds wishing to match future inflation-linked liabilities, like pension payments. In some counties there may also be an advantage for tax payers in holding index-linked rather than conventional bonds because in some jurisdictions tax is payable only on the relatively low coupon payment, based on nominal value (i.e. they are exempt from income tax on the inflation protection element of the coupon, as well as capital gains tax). For issuers of inflation-linked bonds, a key attraction is that they allow the issuer to borrow more cheaply by issuing securities with lower nominal coupons. If the rate of inflation over the life of the bond turns out to undershoot expectations at the time of issue, then the issuer will have borrowed more cheaply still. Finally, it has also been suggested that issuance of inflation-linked bonds by governments sends an inflationfighting message to the market which in itself may help to reduce nominal interest rates and, therefore, borrowing costs. For these reasons, issuing inflation-linked bonds is often seen as a win-win situation for both the issuer and the investor. WHO ISSUES THEM? The main issuers of inflation-linked bonds are sovereign governments/central banks. Since the first issue in the UK in 1981, more and more countries have begun issuing inflation-linked bonds. An increasing number of companies are also issuing inflation-linked corporate debt. 10 AXA INVESTMENT MANAGERS INFLATION-LINKED BONDS IN DEPTH

The largest, most established inflation-linked bond markets include: Country Inflation-linked Bond Issuer Inflation Index United States Treasury Inflation Protected Securities (TIPS) US Treasury US Consumer Price Index (CPI) United Kingdom Index-linked Gilt (ILG) UK Debt Management Office (DMO) Retail Price Index (RPI) France Germany OATi OATei Bund Index Agence France Trésor Agence France Trésor Bundesrepublik Deutschland Finanzagentur France CPI ex Tobacco EU HICP ex Tobacco EU HICP ex Tobacco Hong Kong ibond (domestic retail bonds) Hong Kong Government Composite Consumer Price Index Italy BTP i Department of the Treasury EU HICP ex Tobacco Canada Real Return Bond (RRB) Bank of Canada Canada All Items CPI Australia Capital Indexed Bonds (CAIN series) Department of the Treasury Weighted Average of Eight Capital Cities: All Groups Index Japan JGBi Ministry of Finance Japan CPI (nationwide, ex fresh food) Brazil Notas do Tesouro Nacional Série B Tesouro Nacional IPCA Sweden Index-Linked Treasury Bond Swedish National Debt Office Swedish CPI Source: UK Debt Management Office, August 2016 AXA INVESTMENT MANAGERS INFLATION-LINKED BONDS IN DEPTH 11

THE DEVELOPMENT OF INFLATION-LINKED BOND MARKETS MARKET BEGINNINGS One of the earliest bonds to have its principal and interest linked to the price of a basket of goods can be tracked back to an issue by the State of Massachusetts in 1780. However, the issuance of inflation-linked bonds throughout history has been sporadic and usually out of necessity, by countries experiencing volatile inflation. This backdrop changed in the 1980s when major developed economies began issuing index-linked debt, not out of necessity but as a deliberate policy choice. The UK is credited with launching the first inflation-linked bond of the modern era, when in 1981 the government issued a 1bn inflationlinked gilt available to institutional investors. Soon after, Australia (in 1985), Sweden (in 1994) and New Zealand (in 1995) all started issuing sizeable amounts of ILBs. In 1997, the market saw significant expansion when the US began issuing Treasury Inflation-Protected Securities (TIPS). More recently, France (in 1998), Greece and Italy (in 2003), Japan (in 2004) and Germany (in 2006), have also joined the market as well as Spain in 2014. Emerging markets were the earliest issuers of inflation- linked debt, including Brazil (1964), Chile (1966) and Venezuela (1967). Today, ILGs are now also issued by Mexico, Argentina, Peru, Uruguay, South Africa, Poland, Turkey, South Korea, Thailand and India. Indeed, while the benefits for investors, in the form of inflation-adjusted returns, were clear, academics such as John Maynard Keynes had long argued that a sovereign inflationlinked debt programme would also benefit the sponsoring government. For the issuing government, inflation-linked debt would result in cost savings because risk-averse investors would be willing to pay a premium for inflation protection. RECENT MARKET ENVIRONMENT The global inflation-linked market has gone through a rapid period of growth over the past 20 years. The US TIPS market is now the largest inflation bond market. Considering its relatively recent start, the eurozone market remains the second largest sovereign linker market, in terms of both volumes and turnover. Despite this growth, inflation-linked bonds still account for only a minor, although in most cases, rising, share of total government debt. 12 AXA INVESTMENT MANAGERS INFLATION-LINKED BONDS IN DEPTH

Due to their key function for institutional investors, such as pension funds, and insurance companies, in managing long-term liabilities, the majority of ILBs issued tend to have longer to maturity. One of the criticisms often levelled at ILBs is that, compared to conventional bonds, they represent a much smaller market, with less flexibility in terms of the available maturities. However, as the global ILB market continues to grow and evolve, so too do their criticism becomes less relevant. The global inflation-linked market has gone through a rapid period of growth over the past 20 years. CONCLUSION Inflation-linked bonds offer the potential of a real return to investors, over and above the prevailing level of inflation. This not only protects the purchasing power of investor returns, but generally offers more predictable long-term performance, relative to conventional bonds. Since ILBs provide more predictable returns than conventional bonds, they are pivotal in terms of asset-liability matching investment strategies. ILBs also have tended to show a low historical correlation to equity and nominal bond markets, which can make them an attractive diversifying addition to a portfolio. And with more countries issuing inflation-linked bonds, there is increasing diversity within the asset class, a larger spread of maturities and greater potential for returns. AXA INVESTMENT MANAGERS INFLATION-LINKED BONDS IN DEPTH 13

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