Inflation Hedging Towers Watson

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Inflation Hedging Towers Watson Powered By Docstoc
					           Inflation Hedging
           With Inflation-Linked Bonds
      By Dan Lomelino, Kim Gillett and Marko Komarynsky

      in Emphasis 2010/3, we outlined the risk of elevated inflation to p&C insurers. in this
      follow-up, we examine the viability of various inflation-hedging instruments.

                            Inflation-Linked Bonds                                       Linkers Around the World
                            When discussing inflation hedging, the first                 U.S. TIPS use the Canadian model, with a deflation
                            instrument that usually comes to mind is inflation-          floor. The U.K. was the last of the G7 nations to
                            linked bonds (or linkers). According to Barclays             adopt the Canadian model, in 2007. Most developed
                            Capital, 13 of the 20 largest countries in terms of          countries now also include a deflation floor in their
                            GDP have an inflation-linked market. The largest             inflation-linked bonds.
                            market for linkers in the world is the Treasury
                                                                                         The U.K. has a long history of issuing linkers, dating
                            Inflation-Protected Securities (TIPS) market, issued
                                                                                         back to 1981, and they currently make up 33% of the
                            by the U.S. Treasury. Since its inception in 1997, the
                                                                                         U.K. gilt market, according to Barclays Capital, while
                            TIPS market has grown to approximately $600 billion
                                                                                         U.S. TIPS are less than 10% of the U.S. Treasury
                            in outstanding debt, or roughly 40% of the global
                                                                                         market. U.K. gilt linkers use the Retail Price Index
                            inflation-linked market.
                                                                                         (RPI) as their inflation index. However, since 2003,
                            A U.S. TIPS coupon is a fixed rate determined at             the Bank of England has used the U.K. CPI as its
                            auction. The coupon is applied to an inflation-              inflation target. Recently, the U.K. government
                            adjusted principal dependent on the nonseasonally            announced plans to require that U.K. CPI be used
                            adjusted Consumer Price Index for All Urban                  for future private pension liabilities. As of yet, there
                            Consumers (CPI-U) with a three-month lag. The                are no plans by the U.K. Debt Management Office to
                            inflation-adjusted principal is then paid out at maturity.   issue gilt linkers indexed to U.K. CPI. Given the
                            Unlike the nominal Treasury, the dollar amount of the        expected increased demand by pension funds for
                            coupon payment is unknown at the time of purchase            the CPI linkers, it’s logical to expect there might be a
                            because the principal amount is adjusted monthly             change at some point in the future. Until that time,
                            based on realized inflation. At maturity, the owner of       many believe the gilt linker market will suffer from
                            the TIPS coupon receives the principal back from the         supply-and-demand imbalances.
                            government based on the cumulative total inflation
                                                                                         Sovereign linkers in the Euro-zone are generally
                            that occurred over the life of the bond.
                                                                                         issued with the reference index of the Harmonized
                            It’s important to note that the principal amount can         Index of Consumer Prices excluding tobacco (HICPx).
                            increase or decrease depending on inflation or               In Europe, France was the first to issue inflation-linked
                            deflation. However, the principal paid at maturity will      bonds, and France and Italy are the largest issuers in
                            not fall below par value. This principal protection          the European market. Germany was relatively late in
                            that U.S. TIPS provide can also be thought of as a           issuing linkers, and the German market has been
                            deflation put or deflation floor.                            slow to develop. Greece has also issued linkers, but
                                                                                         its market is less liquid, and its linkers were taken
“The world’s largest market for inflation-linked                                         out of the Barclays indices at the end of 2009.

                                                                                         Because of Japan’s recent history of deflation,
 bonds is the Tips market, issued by the                                                 Japanese linkers have not been as popular among
 U.s. Treasury.”                                                                         domestic investors as in the U.S., U.K. and Europe.
                                                                                         The Japanese suspended issuance of inflation-linked
                                                                                         bonds in the fall of 2008 during the financial crisis.
                                                                                         In 2009, the Ministry of Finance embarked on a

Figure 1. Historical U.S. TIPS breakevens
Breakeven inflation rate (%)




                                                                                                                                   Dan Lomelino
                                                                                                                                   Specializes in
                                                                                                                                   investments and
–2%                                                                                                                                U.S. asset manager
–3%                                                                                                                                Towers Watson,
           June         Dec.   June   Dec.   June   Dec.   June   Dec.    June   Dec.   June   Dec.   June   Dec.   June   Dec.    Chicago
           2003         2003   2004   2004   2005   2005   2006   2006    2007   2007   2008   2008   2009   2009   2010   2010
             Five-Year          Seven-Year      10-Year       20-Year         30-Year

Source: U.S. Treasury

buyback program that retired 40% of the original                        expects inflation to be higher than the breakeven rate
issuance, and it recently announced that there                          would prefer TIPS over nominal bonds, and vice versa.
would be no new issuance of inflation-linked bonds
                                                                        If you sell out of your position before maturity, there
in fiscal year 2011.
                                                                        are many factors beyond the market’s inflation/
Australia also suspended its inflation-linked bond                      disinflation view that can drive the breakeven rate.
program in 2003, but unlike Japan, it did so because                    For instance, the relative value of nominal Treasuries     Kim Gillett
                                                                                                                                   Specializes in
of budget surpluses. In 2009, the Australian                            is considered to be adversely affected by an increase      fixed-income
government reintroduced its Treasury Indexed Bond                       in the inflation risk premium or the risk associated       investments and
program and appears to be committed to its success.                     with increased inflation volatility. Conversely, nominal   U.S. asset manager
                                                                        Treasuries are seen as having a liquidity premium          Towers Watson,
The long history of Latin America linkers was
                                                                        that makes them more attractive; they are preferred        Chicago
precipitated by the devaluations and hyperinflation that
                                                                        by the market during flight-to-quality episodes.
some of that region’s countries have experienced.
The region’s overall success weathering the recent                      The liquidity premium was an especially prevalent
global financial crisis has given Latin American                        issue in late 2008 and early 2009 in the U.S. During
governments more freedom in terms of what type of                       the crisis, investors across the globe had a strong
debt they can issue. Some in the region, such as                        preference for on-the-run nominal Treasuries
Argentina, have stopped issuing linkers, and others,                    because they were seen as the ultimate safe-harbor
such as Mexico, have linker markets dominated by                        investment in the world’s reserve currency. The
domestic investors. Brazil, on the other hand, is the                   market consensus is that this flight to safety was
fourth-largest issuer of inflation-linked bonds in the                  the largest factor in TIPS underperformance relative
world. Latin America has probably the least                             to nominal Treasuries in 2008. However, the massive        Marko Komarynsky
homogeneous market. Latin American countries do                         flight to quality that so negatively impacted TIPS         Specializes in
not entirely follow the Canadian model, and each                        breakeven spreads were compounded by 2008’s                investments and
country has unique aspects to its inflation index.                      economic reality: heightened deflation fears resulting     leads U.S. asset
                                                                        from the shock the credit crisis had on the economy.       manager research.
                                                                                                                                   Towers Watson,
Breakevens and Risk Premiums                                            Overall, 2008 showed that TIPS breakevens can be           Chicago
The yield to maturity on a TIPS is considered a real                    driven by both technical factors, such as liquidity, and
yield — the yield earned over the life of the bond                      by fundamental factors, such as deflationary fears.
over and above the level of inflation that investors                    Using the relative share of each factor (technical
can lock in today. The difference in yield between the                  and fundamental) to compare the performance of
nominal 10-year Treasury and the 10-year TIPS is                        TIPS against nominals can be notoriously difficult
called an inflation breakeven rate. An investor who                     and highly dependent on assumptions.

                                                                                                                                       Emphasis 2011/1 | 17
 Figure 2. Historical secular trends in nominal U.S. yields and inflation



                                                                                                      Inflation Hedging
                                                                                                      Inflation-linked bonds are relatively straightforward
                                                                                                      instruments that provide a direct hedge against
                                                                                                      inflation. If a liability is based on the same reference
   2%                                                                                                 inflation index, the effectiveness of a hedge is
   0%                                                                                                 limited only by any timing mismatch between the
                                                                                                      liability and the bond portfolio. If there is a serious
                                                                                                      timing mismatch, the hedge is exposed to real
    1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010
                                                                                                      interest rate risk as well as fluctuations in the
            CPI-U       10-Year U.S. Treasury
                                                                                                      liquidity and inflation-risk premiums.
 Source: Bureau of Labor Statistics, U.S. Federal Reserve                                             Currently, real yields in many countries still remain
                                                                                                      historically low. Even if rates do normalize, Towers
                                           The inflation-risk premium is also very difficult to
                                                                                                      Watson’s long-term expectation is a 10-year real rate
                                           measure precisely, but it is an important economic
                                                                                                      of only 2% in the U.S. Given this low rate of return,
                                           concept that has been the subject of numerous
                                                                                                      some might choose to look at other potential
                                           empirical economic studies. Studies that have
                                                                                                      inflation-hedging instruments. Figure 3 shows some
                                           measured inflation-risk premium over a long period
                                                                                                      of the positives and negatives of popularly
                                           of time in the U.S. and U.K. show that the inflation-
                                                                                                      mentioned inflation hedges.
                                           risk premium can vary considerably. More recent
                                           studies in the U.S., U.K. and Euro-zone that used          As Figure 3 illustrates, while commodities and
                                           data from inflation-linked bond markets estimate           equities do have their advantages, they are
“inflation-linked bonds are                that the inflation-risk premium has been smaller and       fundamentally incomplete hedges. For instance, a
 relatively straightforward                relatively more stable.                                    future increase in the CPI could be the result of
 instruments that provide                                                                             higher medical costs because of demographic shifts.
                                           The notion that the inflation-risk premium is smaller
                                                                                                      Equities are also mentioned predominantly as an
 a direct hedge against                    and more stable might be the result of a belief that the
                                                                                                      inflation hedge, but in a stagflation scenario, it is
 inflation.”                               major central banks have gotten better at fighting
                                                                                                      unlikely that many equity sectors will perform well.
                                           inflation. The best example of this is probably the
                                                                                                      Some equity sectors, such as financials, will most
                                           U.S. Federal Reserve. After a long period of
                                                                                                      likely underperform under any inflation scenario.
                                           stagflation, the U.S. started to experience relatively
                                                                                                      Other sectors, such as industrials or technology,
                                           benign inflation in the early 1980s. The move to a
                                                                                                      might do well under some inflation scenarios, but
                                           lower level of inflation corresponded with a decrease
                                                                                                      not necessarily under every inflation scenario.
                                           in both nominal and real yields (Figure 2).
                                                                                                      There are economic arguments for using commodities,
                                           It is also believed the inflation-risk premium has
                                                                                                      equities or real estate as an inflation hedge. But
                                           decreased. If the inflation-risk premium has, in fact,
                                                                                                      these assets are more risky and more volatile than
                                           come down as a result of improved inflation-fighting
                                                                                                      inflation-linked bonds, with greater upside potential
                                           performance by central banks, the implication is that
                                                                                                      and downside risk. Ultimately, if the primary goal is
                                           inflation-risk premium could rise if the central banks
                                                                                                      to hedge inflation, inflation-linked bonds should
                                           started to lose some of their credibility. That is to
                                                                                                      provide a greater level of protection because a linker
                                           say, if the Fed is currently in the early stages of an
                                                                                                      is the only nonderivative security that has an explicit
                                           easy-money policy that is sowing the seeds of future
                                                                                                      link with inflation. That should imply that linkers offer
                                           increased inflation, not only would TIPS do well
                                                                                                      a larger measure of protection against inflation over
                                           from increased realized inflation, they would also
                                                                                                      a greater number of economic scenarios.
                                           outperform most other assets due to an increase in
                                           the inflation-risk premium.

Figure 3. A look at popular inflation hedges
 Instrument               Positives                                           Negatives
 Commodities              • High historical correlation to CPI                • Incomplete hedge
                          • No sovereign debt risk                            • Hard to implement. Which commodities? How to invest?
 Equities                 • Hedge attained by ownership in real assets        • Hedge unlikely to work in stagflation scenario similar to 1970s
                          • Exposure to equity market appreciation            • Equity sectors will not react to various inflation drivers in same way
 Real Estate              • Hedge attained by ownership in real assets        • Direct real estate investments have investability and liquidity issues
                          • Makes up large part of many inflation indices     • Bubbles in U.S. and elsewhere raise validity concerns
 Inflation-Linked Bonds   • Complete hedge for life of bond                   • Sovereign debt risk, usually results in locking in of minimal real return
                          • Regulatory and accounting benefits                • If timing mismatch, then face rate risk and changes in risk premuims
 Inflation Derivatives    • Ability to build highly customized hedges         • Historically expensive with counterparty risk
                                                                              • Complicated to implement with accounting implications

On the opposite end of the spectrum from                         Ultimately, while inflation-linked bonds do have
commodities and equities is the highly customized                positive and negative aspects, there is no single
approach to inflation hedging achieved with inflation            inflation hedge that will work for every investor in
derivatives. An inflation swap is one example of an              every situation. Companies interested in pursuing
inflation derivative and is very similar to the better-          an inflation-hedging program would do well to work
known interest rate swaps. For instance, a client                with a knowledgeable consultant.
who is worried about an increase in inflation might
                                                                 For those seriously considering a linkers hedging
pay a predetermined fixed rate and receive the CPI
                                                                 strategy, a major stumbling block could be the
inflation rate over the life of the contract. Someone
                                                                 current low interest rate environment in many
who is worried about disinflation or deflation might
                                                                 countries. However, if the main concern is to hedge
take the other side of that trade. Other types of
                                                                 inflation, timing the market in an effort to wait for
inflation derivatives can include inflation caps and
                                                                 rates to normalize is not without its own set of risks.
floors, and real rate swaps.
                                                                 First, it is possible that higher realized inflation
Derivatives are subject to counterparty risk,                    would be accompanied by lower real rates. This type
regulatory and accounting concerns that limit their              of stagflation scenario could occur in the U.S., for
effectiveness for many insurance clients. In addition,           instance, if there is a dollar crisis that pushes
recent academic research by Matthias Fleckenstein,               nominal yields up, increases inflation and results in
Francis A. Longstaff and Hanno Lustig has shown                  lower real economic growth.
that TIPS have historically been underpriced relative
                                                                 If inflation does increase, a more likely scenario
to a synthetic TIPS portfolio of nominal Treasuries
                                                                 would be that real rates normalize and move higher
and inflation swaps. While the highly customized and
                                                                 in Europe and the U.S. as a result of a continued and
tailored solutions that inflation derivatives provide
                                                                 strengthening recovery. But it is never a good idea
might be of interest to some, inflation derivatives
                                                                 to buy insurance after the fire has already started.
have historically been a relatively expensive hedge with
                                                                 If inflation starts to become an issue, linkers could
many practical issues that limit their effectiveness.
                                                                 outperform many other asset classes as more
                                                                 market participants seek the inflation insurance this
Conclusion                                                       sector provides. In the scenario where realized
From an implementation standpoint, inflation-linked              inflation increases and real rates move higher, the
bonds are superior to other assets from a risk-based             wisdom of waiting will be highly dependent on the
capital perspective. Inflation derivatives do allow for          company portfolio’s current allocation.
a more customized solution relative to inflation-
                                                                 For comments or questions, call or e-mail
linked bonds, but even for those property & casualty
                                                                 Dan Lomelino at +1 312 525 2232,
insurers with derivative capabilities, the adverse
accounting treatment of derivatives versus linkers                                                                                The authors would like
                                                                 Kim Gillett at +1 312 525 2363,
will make them an unlikely option for many. For an                                                                                to thank steve Lowe and
                                                       ; or
insurance company, inflation-linked bonds provide
                                                                 Marko Komarynsky at +1 312 525 2362,                             Tom mcintyre for their
the most complete inflation hedge in most economic
                                                                                      help with and contributions
conditions. From a practical standpoint, they are
also much easier to implement.                                                                                                    to this article.

                                                                                                                                         Emphasis 2011/1 | 19

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