Archive for January, 2017

Linking Fortunes

Markets have begun to think about inflation again. In the US the new President is expected to contribute further towards existing pressure on prices; in Britain the weak pound has led to imported inflation as we saw again only this week. Talk in some quarters has turned, quite reasonably, to inflation protection, and specifically to index-linked bonds. This post is for anyone who is unsure what these are or how they work.

The UK was the first significant issuer of index-linked sovereign debt beginning in 1981. Details of the history and mechanics of the market are available from the Debt Management Office (DMO) website here. But the gist is as follows.

Gilts pay coupon interest semi-annually and repay principal on maturity. In an inflationary environment the real value of these interest and principal payments falls over time. So index-linked gilts, or “linkers”, have their coupon and principal varied in line with the Retail Price Index (RPI, the old measure of inflation, as distinct from the CPI measure which the Bank of England still officially targets).

Complicating things slightly there are two sorts of linker. The first, older variety lag RPI by eight months. This is to allow coupons to accrue on the basis of known values: a payment due in six month’s time will be based on the RPI print from two months ago (the additional month allowing for revision to the initial data release), so there is no uncertainty. Reflecting advances in technology, this type of gilt was superseded in 2005 by another which lags by only three months. This still allows for data revisions but by adjusting coupon and principal payments during accrual periods it follows RPI more closely over the life of the bond.

One further concept to mention is the breakeven inflation rate. This is the rate at which RPI would have to run to equalize returns between conventional and index-linked gilts of the same maturity. At present the benchmark ten-year linker yields -1.8% (these yields are always quoted in real terms). The ten-year conventional gilt yields 1.4%. So if RPI runs at 3.2% over the life of the bonds the linker will end up paying the same as the conventional. This tells investors about the relative value of the two types of security at different times, and about the market’s view on RPI inflation of course.

Index-linked gilts are the key securities for investors looking to protect themselves against UK inflation, as measured by the RPI. Of course in the event of RPI deflation then linker payments are cut rather than increased, which is something to bear in mind, as is the tax treatment: while gilt coupons are taxable as income any change in principal, including the full value of the indexation uplift, is completely tax free.

There are some index-linked corporate bonds in issue too. Like ordinary corporate bonds these pay a spread over government bonds to reflect credit risk and other things, but corporate linkers also track RPI in the same way as gilts. For individuals investing outside a tax wrapper, however, there is bad news. Unlike gilts, the principal uplift on corporate linkers is taxable – and taxable as income at that . . .

Of course the UK is not the only country to issue linkers. There is a sizeable French market, for instance. This offers bonds linked to two indices: the standard CPI and the CPI ex tobacco. Other eurozone countries also have index-linked government bonds in issue, which gives investors the opportunity to take views on respective inflation rates for different economies while bearing the same currency risk.

Some emerging market borrowers also issue linkers. Here, of course, currency volatility can be very high. But if inflation is imported on the back of currency weakness this benefits index-linked securities. In 2015 for instance the Brazilian real lost 49% of its value against the dollar. Year-on-year CPI peaked at 10.7%. And over the course of the year, the conventional government bond maturing in 2025 returned -8.1% while the 2024 linker returned 9.9%. For those interested in emerging market debt, then, there are times when indexation can be a helpful angle – where it is available of course.

Less exotically, the largest issuer of linkers is the US government by way of Treasury Inflation-Protected Securities (“TIPS”). The value of this market is currently $1.2trn (as against £603bn for index-linked gilts). TIPS seem to have found their strongest ever following at present. And not without reason: US breakevens from five years onwards are at about 2%, as against a 20-year average for CPI inflation of 2.2%. Should the US economy be entering a period of above average inflation, therefore, TIPS would offer value relative to conventional Treasuries – while giving dollar investors protection from the real-terms erosion of their wealth of course.

Index-linked securities are generally less volatile than conventionals, or thinking about this another way, even more boring. But there can be a place for dullness, or dependability, in portfolios. And in the event of a serious inflationary outbreak, linkers could well turn out to be the best bet in town. It is no coincidence that the British government first issued them on the back of a report from a committee that started work under Harold Wilson in 1977 – a short time after the oil crisis and a year over which UK inflation averaged 16%.

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20/01/2017 at 6:39 pm

2016: By The Numbers

The year just gone was noteworthy for its political surprises. Events of great magnitude such as the Brexit vote, the election of Donald Trump and the collapse of the Renzi government might be marked “good” or “bad” according to taste; under “ugly” the threat of terrorism reminded us of its presence by way of some glaring atrocities in Nice and elsewhere. Markets, too, were haunted by fear for much of 2016. We began the year apparently convinced that the financial world would be eviscerated by a Chinese economic collapse, or sequel to the global banking crisis. But while they were haunted by fear markets were not to be governed by it – at least not exclusively.

After some periods of exceptionally high volatility most major stock markets closed the year higher. The S&P 500 returned +11.8%, the Nikkei 225 +2.1% and the Euro Stoxx 50 +4.4%. Leading the pack was the FTSE 100 with +18.6%, its highest return for any calendar year since its recovery post crash in 2009.

As many observers noted – especially those inclined to file Brexit under “bad” – this stupendous performance was to a large degree attributable to translation effects, with much of the large cap index’s earnings coming from abroad. (The FTSE 250 by way of comparison did +6.5% – nothing to be sniffed at but clearly not so much a beneficiary of the weak pound.)

And how the pound did weaken! It lost 16% of its value against the dollar, 14% against the euro, 18% against the yen and 15% against the Swiss franc, its worst performances since 2008.

The distorting effect of the currency on the return profile of international assets to sterling investors was accordingly enormous. The MSCI indices for the developed and EM worlds returned +8.0% and +11.2% respectively last year; in GBP terms those figures rocket to +28.9% and +32.7%.

Look at the EM equity markets individually and the effect was compounded in certain cases by currency strengthening on the other side. The Bovespa Index (Brazil) had a great rally in local terms anyway, up 39%. Since the real also had a super year its sterling terms return was +105%.

Brazil (and Russia) were helped by a recovery in commodity prices which had seemed unthinkable at the start of the year. Oil, whose price collapse had been so very influential, rallied strongly with the near Brent future rising +52.4% (+81.9% GBP). Natural gas did slightly better. The other start performer in commodity world was zinc, up 61%, reflecting renewed demand for steel in China. Other indicators of global economic activity also enjoyed a buoyant 2016 overall, with the Baltic Dry freight index up 101% and the WCI Composite (container) index putting on +65%. At the other end of the pile were some of the other base metals and gold, which did only +8.6%, despite some shows of promise during the year’s various periods of panic and confusion.

With risk assets having more than recovered themselves and energy prices up significantly overall, one might have expected the key bond markets to suffer. As indeed they did – but only into the closing weeks of the year. This turned out not to be enough to take the shine off the massive, record-breaking rallies they were able to set when the sky was falling in. The BofA ML conventional gilts index returned +10.6% last year, while their index-linked cousins trounced even the FTSE 100 with a return of +25.2%. Germany and Japan also saw positive returns (+4.1% and +3.3%), and even the US, where yields were boosted by Trump’s victory, saw an overall positive TR of +1.1% (or +20.6% in sterling terms).

Hard currency emerging market bonds outperformed on the back of spread compression to deliver +9.0% (reflecting a mix of dollar and euro exposure). But the real winner in the credit space, outperforming equity even in the positive year that was 2016, was high yield. The US HY index delivered +17.5% last year (+40.1% in GBP), with euro HY putting on +9.1% (+26.3%).

Finally, property. This was a mixed bag, depending not least on how one approached investing. Anecdotal fears of a negative Brexit effect into the summer were borne out by IPD data on commercial property, with UK prices falling by over 4% to September from their February peak. They recovered very slightly into year end, however, and with rental yield on top the asset class managed a positive total return of +2.6%.

If one had bought REITs rather than buildings, however, the story was different. Falling price/book ratios as sentiment deteriorated saw the sector deliver -7.0% – along with the Chinese stock market, one of the very few negative numbers delivered over the twelve months as a whole. Meanwhile, housing pursued a different path altogether, with residential property prices for the UK still rising at a pace of +6.9% over the year to October.

2016 was a truly extraordinary year in many areas, and asset class returns was one of them – especially for those of us with sterling as our reference currency. It started out as Armageddon, but as these numbers show, the hard thing for investors in hindsight would have been to avoid making money.

Does this mean markets are heading into the New Year with a false sense of confidence?

We will know for sure in another year’s time.

06/01/2017 at 6:47 pm


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