Guarding against the inflation dog in emerging markets

June 6, 2013

The dog that didn’t bark was how the IMF described inflation. But might the fall in emerging market currencies reverse the current picture of largely benign inflation?

Nick Shearn, a portfolio manager at BlueBay Asset Management, sees the rise in inflation as not an if but a when, which makes inflation-linked bonds (linkers in common parlance) a good idea. These would hedge not only against EM but also G7 inflation — he calculates the correlation between the two at around 0.8 percent. He says linkers outperform as inflation uncertainty increases, hence:

As a result of the loose monetary policies of recent years that have been implemented to promote growth within emerging market economies, we believe rising as well as persistent inflation should become a trend….. Currently we are seeing the early signs of an inflation dynamic in isolated countries such as in Brazil. But, as inflation begins to rise across the region, inflation uncertainty will also begin to rise and consequently inflation-linked bonds should perform well.

The way linkers work is that the principal of the bond is indexed to inflation and the coupon is calculated using the nominal rate and the inflation index. A rise in inflation expectations would lead to a higher coupon.

There has indeed been some investor interest in EM linkers of late. State Street Global Advisors’ ETF arm, SPDR Europe, in April launched the first exchange-traded fund for EM inflation-linked bonds. It said at the time that three-quarters of the investors it surveyed expected global inflation to rise in the next 1-3 years, with developing countries especially hard hit.

One problems for investors though has been that emerging market linkers are relatively few. State Street puts the value of this market at a trifling $600 billion (total local currency emerging debt in comparison amounts to over $7 trillion). Issuance is concentrated in a few countries — Brazil, South Africa, South Korea and Poland have issued most of the EM linkers that are out there.  But the market is growing. Shearn notes a growing linker curve in Thailand, while Indonesia and Philippines are also considering issuance.

The latest entrant to the market is India, which saw good demand at its first ever linker auction this week and plans to sell up to $2.7 billion worth of bonds in the fiscal year to March 2014.   But the Indian linker plan is likely to share the problems faced by many other EM linker markets — thin liquidity as a result of dominance by local banks and pension funds who are usually buy-and-hold investors.  says Steve O’Hanlon, head of fixed income at ACPI Investment Managers. But he is not yet buying the Indian linker. O’Hanlon says:

(Issung inflation-linked bonds) sends a message the authorities are not massively concerned about inflation going forward and that’s a positive. But we don’t know how the liquidity will be and how much they will roll out ultimately. Most importantly, how effective will it be in determining what inflation expectation will be if the market becomes illiquid very quickly. 

Analysts at Barclays are not too keen on the Indian linker either. India’s motivation in issuing an inflation-hedged instrument is to wean locals off their addiction to gold, and given expectations of 5.3 percent inflation this year, Barclays reckon the bond needs a real yield of at least 1.75 percent to be attractive. But huge local demand could drive real yields to around 1.25 percent, they reckon.

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