November 2013

EDHEC RESEARCH: Inflating challenges

Helium balloonInflation-hedging is not as straightforward as it seems. The Edhec-Risk Institute explains how to approach this topic with fixed-income instruments. In the presence of increased uncertainty about future price levels in developed economies, inflation hedging has become of critical concern for most investors, including pension funds. From an investment solution perspective, the implementation of inflation-hedging portfolios seems to have become relatively straightforward given that inflation-linked (IL) bonds issued by various sovereign states can be used to achieve effective inflation hedging. In practice, however, Treasury inflation protected securities suffer from a number of severe drawbacks. First, the market capacity for these inflation-linked bonds is often limited and some large investors are unable to allocate to this asset class as much as would be optimal. A second, related, drawback is that Treasury inflation protected securities (TIPS) offer inflation protection at a prohibitive cost. Due to increasing demand from institutional investors, market prices for TIPS have soared in most countries, and real yields have dramatically declined. Finally, and perhaps most importantly looking forward, the increasing concern over sovereign risk has led investors to question the role of sovereign bonds in their portfolio, regardless of whether or not they offer inflation protection. In this context, long-term investors are turning to other investment vehicles for inflation-hedging purposes. No readily available and effective solution has been found to meet the inflation hedging challenge. For example, dedicated over-the-counter (OTC) derivatives such as inflation swaps suffer from the presence of counterparty risk, an obvious preoccupation for long horizons. INFLATION HEDGING V LIABILITY HEDGING
Regardless of whether various asset classes may turn out to be effective or not at hedging inflation risk, it also has to be recognised that investing in asset classes other than fixed-income instruments is in any case extremely risky in the context of liability-hedging portfolios. In other words, it is important to emphasise the key difference between inflation hedging and liability hedging. While the two concepts coincide at liability maturity, they are very different in general. Short-term (instantaneous) liability risk is driven by two main risk factors: inflation risk and interest rate risk. From a mathematical viewpoint, interest rate risk affects instantaneous liability risk through the impact on the discount factor, an impact that increases linearly with time-horizon. Inflation risk, on the other hand, affects the value of the liabilities through an impact on the cash-flows, which is not affected by time-horizon. In fact, it is only in the case of exceedingly short horizons, such as a year. For the shortest investment horizon we consider (one month), we find that nominal bonds have good liability-hedging properties at short horizons, with a correlation equal to 0.8 with respect to liabilities with a one-year duration, and a value extremely close to 1 for liabilities with a duration exceeding 10 years. However, when the investment horizon increases, their correlation with liabilities decreases, both in absolute and in algebraic value, and eventually becomes zero, or even, negative when the investment horizon is taken to coincide with the duration of the liabilities. Conversely, inflation-linked bonds exhibit low, and even slightly negative short-term correlation with changes in inflation, but they have a perfect correlation with liabilities at all horizons. In this context, it turns out that for reasonable parameter values, interest rate risk dominates inflation risk so substantially that introducing assets (like commodoties) with attractive inflation-hedging properties but poor interest rate hedging capacities will decrease, as opposed to increase, investors’ welfare. Emphasising the difference between liability-hedging and inflation hedging, we finally find that inflation-linked bonds are the only assets that allow for attractive liability-hedging properties at all horizons, and as such we expect them to add substantial value in investors’ liability-hedging portfolios. Overall, it thus appears that a trade-off exists between using inflation-linked bonds, which are securities that offer explicit and built-in inflation protection as well as controlled interest rate exposure, but do so at a prohibitive cost, and using securities such as stocks or real assets, which offer higher expected performance but imply a substantially higher risk with respect to the liabilities from a short-term perspective. Recent research conducted as part of the “The Case for Corporate Bonds: Issuers’ and Investors’ Perspectives” research chair at Edhec-Risk Institute, supported by Rothschild & Cie, argues that a possible way out of dilemma exists, which consists in investing in corporate inflation-linked bonds, which are assets with well-defined interest rate risk exposure, built-in inflation indexation, and which provide cheaper access to inflation hedging compared sovereign inflation-linked bonds. Credit risk obviously also exists for corporate bonds but at least the presence of credit risk in corporate accounts is well understood and documented. This is in sharp contrast to sovereign credit risk, given that sovereign state accounts are hardly audited. In this context, investment-grade corporate bond markets offer better stability and visibility than sovereign bond markets. Besides, using inflation-linked corporate bonds in inflation-hedging portfolios would also provide pension funds with a hedge against changes in regulatory liability value, in the context of the international accounting standards SFAS 87.44 and IAS19.78, which recommend that pension obligations be valued on the basis of a discount rate equal to the market yield on AA corporate bonds. CONCLUSION
While a dominant fraction of inflation-linked debt is still issued by sovereign states, there has been recent interest amongst various state-owned agencies, municipalities and also corporations, in particular utility or financial-services companies, in issuing inflation-linked bonds. Our research argues that inflation-linked bonds, in addition to being attractive for issuing corporations, are also attractive for investors such as pension funds facing long-term inflation-linked liabilities. Overall, such investors face a challenge and a dilemma. On the one hand, inflation-linked bonds offer explicit and built-in inflation protection as well as controlled interest rate exposure, but they do so at a prohibitive cost so that most of the benefits are purely related to hedging benefits. On the other hand, securities such as stocks or real assets offer higher expected performance and reasonable inflation-hedging benefits, but they imply a substantially higher risk with respect to the liabilities from a short-term perspective since their exposure to interest rate risk, which dominates short-term liability risk, is not managed. The results of our research suggest that a possible way out of dilemma exists, which consists in investing in corporate inflation-linked bonds, which are assets with well-defined interest rate risk exposure, built-in inflation indexation, and which provide a cheaper access to inflation hedging compared sovereign inflation-linked bonds. The benefits of investing in corporate inflation-linked bonds are even more substantial when the regulation imposes the use of a credit-sensitive discount rate for liabilities. In this context, it can be expected that the market for corporate inflation-linked bonds will develop substantially in the future. Overall, our results suggest that inflation-linked bonds are ideally suited as liability-hedging instruments for investors facing inflation-linked liabilities discounted at an AA discount rate. This is an edited version of a paper – The Benefits of Sovereign, Municipal and Corporate Inflation-Linked Bonds in Long-Term Investment Decisions – written by Romain Deguest, Lionel Martellini, and Vincent Milhau of the Edhec-Risk Institute ©2013 funds europe

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