Why Asian investors must get real about inflation protection

More Asian governments are set to issue inflation-linked bonds, but amid increasing correlation to developed markets, global inflation-linked bonds are the best play, says Axa IM.
Why Asian investors must get real about inflation protection

The question of how institutional investors and businesses in Asia should protect themselves against Asian inflation was one that had delegates talking on the opening morning of AsianInvestor’s annual investment summit in Hong Kong this week.

“Hong Kong definitely knows what inflation means,” Marion Le Morhedec of Axa Investment Managers told the 250-strong audience at The Conrad hotel, noting that the IMF forecasts 5.8% inflation for the city this year and 4.4% for 2012.

Yet Le Morhedec, the firm’s head of investment portfolio management and director of global rates and fixed income, acknowledged the scarcity of Asian issuers of inflation-linked bonds.

There are 100 outstanding issues globally in seven locations, dominated by the developed markets of the US (36% share), UK (26%) and eurozone (24%). But there is hope for Asian investors, both now and in the future.

Le Morhedec pointed to the increasing correlation between local consumer price indices (CPIs) in Asia and those of developed markets. Taiwan’s CPI, for example, is now 80% correlated to that of the US, and this increase is similarly seen in China, South Korea and Singapore.

“It means inflation is a global problem,” she said. “Of course you will probably have higher inflation in Asia. But to protect against Asian inflation, it is best to go for global inflation instruments.”

A question from the audience was whether CPI numbers could be trusted, given likely changes to the way governments calculate their figures in the future.

Le Morhedec acknowledged this as a potential sticking point in the UK in particular, but stressed that Axa IM trusts the figures from statistical agencies that are independent of governments.

On a positive note, Le Morhedec noted that growing demand for inflation-linked bonds in emerging markets will also prompt more issuance, including in Asia. Already the Emerging Markets Inflation-Linked Bonds Index itself amounts to about $400 billion.

Brazil represents more than 50% of this index, and there is little Asian choice. But Le Morhedec notes that Thailand has mandated plans to launch inflation-linked bonds in coming weeks, while Hong Kong is supposed to issue a retail note to investors by the summer and Taiwan and India are also understood to be enquiring about market conditions.

“There is huge investor demand [for these products] and [Asian] governments should address this demand,” she says of why Asian markets might want to launch inflation-linked bonds.

“It’s also a question of credibility. By issuing inflation-linked bonds they are showing strong commitment to fight inflation. We are clearly expecting some interesting developments. More countries will be represented in the global inflation-linked bond index.”

The best short-term hedge against unexpected inflation shock is commodities exposure, although not in the intermediate or longer term, says Le Morhedec.

“Currently we are starting to speak [to clients] more about real assets that provide real rates of return. These are inflation-linked bonds, real estate, equities linked to commodities and commodities,” she adds, suggesting inflation-linked bonds are the best options, both held to maturity and actively managed.

In terms of inflation expectations, Le Morhedec says developed markets will increasingly be importers of inflation, firstly due to the strength of emerging-market currencies, and secondly because of the fact that wages are rising.

“We also see that developed countries need to pay the same price for commodities, even though their demand is not so strong. So basically the higher inflation we are seeing in emerging countries is going to be translated into higher inflation as well for developed markets.”

Overall, 99% of inflation-linked bonds are sold by governments, with a few sold by government guaranteed agencies and by corporates. The biggest buyers of inflation protection are insurance firms, pension funds and, notably over the past few years, central banks, especially in Asia.

“Asian central banks have reserves in US dollars and they see the dollar weakening, so it makes sense to diversify assets in Tips (treasury inflation-protected securities) rather than nominal bonds,” says Le Morhedec.

In terms of return expectations, since 1997 inflation-linked bonds have offered an annualised return of 6.9% with a volatility of 4.9%, compared with annualised returns of 5.2% for the S&P500 with 16.7% volatility. This, notes Le Morhedec, suggests an appealing risk/return profile.

In terms of actively managing inflation-linked bonds in a portfolio, Axa IM is taking a view on inflation breakevens being long or short and taking positions on the breakeven curves and real-rate curves. It also actively arbitrages inflation.

“The advantage of having low-inflation portfolios is to be able to actively overweight one country against another in order to benefit from the different dynamics of inflation and of interest rates,” says Le Morhedec.

Axa IM manages over $23 billion in inflation-linked bonds globally.

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