Trillion-Dollar Linker Deluge

Around the world, governments are issuing record volumes of bonds linked to consumer prices, betting that inflation will stay low.

Governments from the U.S. to Italy are boosting sales of inflation-linked bonds, wagering consumer prices will remain in check even after central banks inundated the world with cheap cash.

Thirty-five nations issued $1 trillion of the securities in the past three years, the most on record, according to data compiled by Bloomberg. The amount of government debt in developed countries tied to consumer prices is now equal to 7.9 percent of the fixed-rate sovereign bond market, the most since 2008, index data compiled by Bank of America Merrill Lynch show.

While cost-of-living increases in the industrialized world have never been smaller during an expansion, demand for the notes shows investors aren’t ready to declare that inflation is dead yet after central banks from the U.S. to Japan printed record amounts of money to kick-start their economies. In emerging markets, a currency rout roiling nations from South Africa to Turkey is already igniting inflation and threatening to add billions of dollars to government debt costs.

“A number of countries that issued index-linked bonds have been through a recession in the past few years, so naturally they think inflation will remain low for a long time,” Salman Ahmed, the global strategist at Lombard Odier Investment Managers, which oversees $46 billion, said in a telephone interview from London. “But some investors seem to have the opposite view. If inflation surges more than borrowers envisage, they could become an expensive form of funding.”

Known as linkers, the bonds allow investors keep pace with inflation because the value of the securities increases as consumer prices rise. When living expenses remain low, issuers can reduce their upfront borrowing costs because linkers pay less in interest than fixed-rate securities.

In the U.S., $15 billion of 10-year Treasury Inflation Protected Securities, known as TIPS, were sold at a yield of 0.661 percent on Jan. 23. Similar-maturity fixed-rate Treasuries yielded 2.78 percent on the same day.

Yields were 0.51 percent on the TIPS and the 2.68 percent on the nominal notes today as of 1:00 p.m. in New York.

Demand for linkers has increased as central banks globally dropped interest rates to record lows following the financial crisis and the Federal Reserve, the Bank of Japan, and the Bank of England flooded the world with money by buying bonds.

Since 2007, central bank assets around the world have almost doubled, to $20.5 trillion, under asset-purchase programs designed to boost growth and prices, according to a June report from the Bank for International Settlements.


Issuance Surges

Sales of linkers worldwide have exceeded $300 billion for three straight years, the first time that’s happened on record, data compiled by Bloomberg show.

Last year’s $315 billion in issuance helped increase the market for inflation-linked debt since the end of 2010 by almost 40 percent to about $2.3 trillion, the data show.

The U.S., the world’s largest debtor nation, issued a record $155 billion last year. Italy, the second-largest seller of linkers in dollar terms in 2013, offered 46 billion euros ($63 billion), more than double the amount in 2008.

A number of countries have also resumed sales or started issuing for the first time. Japan issued the debt securities last quarter after a five-year hiatus. New Zealand began selling linkers in October 2012 for the first time since 1999.

Spain and Belgium said they plan to introduce the notes if market conditions allow.

“As long as there is some inflation risk premium priced in, meaning inflation expectations are above what the market prices is likely to occur, then there’s an argument to issue such bonds,” Anton Heese, head of European inflation research at Morgan Stanley, said in a telephone interview from London.

The gap between five- and 10-year index-linked bond yields in the global market widened to 0.69 percentage point last month, more than at any time since 2011, according to index data compiled by Bank of America. The so-called steeper real yield curve is a sign of increasing risk that living costs globally will rise at a faster pace as the decade progresses.

Price-growth expectations in the euro region, as implied by the gap between five- and 10-year inflation swap rates, widened to 0.47 percentage point on Feb. 7, the most since July 2012. In the U.K., a gauge of inflation expectations in the five years starting 2019, known as five-year, five-year forward break-even rate, was at 3.33 percent today. That’s more than the average 3.27 percent over the past three years.


Living Expenses

While countries that issued linkers benefited by lowering their debt costs, investors in the bonds suffered unprecedented losses last year as price pressures from central bank stimulus dissipated, signs of disinflation emerged, and the Fed moved to curtail its bond purchases.

Consumer prices for advanced economies increased 1.4 percent last year, according to the International Monetary Fund. Living expenses have never risen less during an expansion since at least 1980, the first year the IMF figures begin. When the jump in linker sales began in 2011, inflation was 2.7 percent.

Linkers in developed nations lost 4.5 percent last year, the first decline since at least 1997, index data compiled by Bank of America show. In the U.S., TIPS tumbled 9.4 percent in the biggest annual drop since they were introduced 16 years ago. Living costs in the world’s largest economy rose 1.48 percent last year, the least since prices fell in 2009 and less than half the pace in 2011.

This year, inflation-linked bonds in developed markets have all advanced, with securities issued by Germany producing their best January returns since 2008. Demand for 52-year notes in a U.K. sale last month reached a record, a sign that investors are hedging their bets on inflation.

“What the market is telling you is that there is low expectation of deflation risk going forward,” Kari Hallgrimsson, head of European inflation trading at JPMorgan Chase & Co. in London, said in a telephone interview. “The market is expecting normalization of inflation. Expectations for the future are higher than they are now.”

A one-percentage point increase in consumer prices could raise Italy’s funding costs on its linkers by about 17 billion euros, according to Morgan Stanley. Living costs in the euro region, to which Italian index-linked bonds are tied, will rise 1.5 percent next year after gaining 1.1 percent this year, the median forecast of economists in the Bloomberg survey showed.

The tying of bonds to prices dates back to at least the 18th century, with the state of Massachusetts issuing bills linked to the cost of silver on the London Exchange in 1742.


Disinflation Risk

Israel was one of the first countries to offer inflation- linked debt when it issued the securities in 1955. The U.K. began selling in 1981, while the U.S. followed in 1997.

Prolonged disinflation may still be the greater risk in developed markets, especially in the euro region as joblessness above 10 percent constrains consumer demand.

Inflation in the 18 nations that share the currency was 0.7 percent in January from a year earlier, less than half the European Central Bank’s target and the fourth straight reading below 1 percent. As recently as November 2011, consumer prices climbed at a 3 percent annual pace.

“It could take years for these problems to resolve,” Jamie Stuttard, head of international bond management at Fidelity Investments, which oversees $1.7 trillion, said in a telephone interview from London. “There is a strong sign of disinflation particularly in euro zone.”

The opposite is happening in emerging markets, where inflation is accelerating. Price pressures are being compounded by investors pulling money from developing nations as the Fed scales back its stimulus, weakening currencies from the Turkish lira to the South African rand.

Emerging-market currencies have swooned, with the lira plunging to a record and the rand tumbling to the lowest since 2008. In Latin America, an index tracking the region’s foreign-exchange rates slumped to the weakest in a decade this month. Currency depreciation adds to price pressure by making foreign goods more expensive to buy.

Turkey responded by more than doubling its benchmark interest rate to 10 percent and South Africa lifted rates for the first time in five years. Still, Goldman Sachs Group Inc. predicts inflation in developing nations will rise to 4.4 percent by 2015 from 3.8 percent at the end of last year.


More Worried

That may result in higher servicing costs for linkers. In South Africa, where the inflation rate rose to 5.4 percent in December from a low of 3.4 percent in 2010, the government would incur an extra 1.69 billion rand ($152 million) for every 10 billion rand of issuance if living costs rise to the 6.4 percent implied by the 10-year break-even rate.

The country has 188 billion rand in linkers, according to data compiled by Bloomberg.

While the currency rout may accelerate price increases in emerging markets as the Fed continues to pull back, U.S. policy makers pledged to keep their five-year-old policy of near-zero rates to support consumer demand. At the same time, Barclays Plc, Commerzbank AG, and Morgan Stanley all predict the ECB will cut its key rate from a record-low 0.25 percent.

“In the long-term, we are worried about inflation,” David Hooker, a senior money manager at Insight Investment Management Ltd., which has $450 billion in assets, said in a telephone interview from London. “While the short-term outlook is benign, we are beginning to wonder if the outcome of the current policy is one of much higher inflation.”

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