Demand likely to remain high for inflation linked bonds despite better inflation outlook

Shalin Bhagwan, Head of Fixed Income at Ashburton Investments.

Demand for inflation-linked bonds, especially those with longer maturities, tends to be a case of feast of famine. Buyers of long-dated inflation linked paper have very specific requirements and their demand tends to come in spurts. National Treasury’s preponderance with issuing longer-dated inflation linked paper means that inflation-linked bond auctions can either be very well supported or very poorly supported depending on whether investors are in a buying cycle or not. In other words, there were periods when buyers were strongly motivated but equally the auctions were prone to long periods when buyers were absent from the market.

Recently it was noted in the media that National Treasury may struggle to sell inflation-linked bonds given the slightly more benign outlook for inflation.

However, Ashburton Investments is of the view that long-dated inflation linked bonds (or linkers as they are known) will continue to be demanded by South Africa’s Liability Driven Investment (or LDI) investor base. Liability Driven Investing is a specialist asset management skill which is used by pension funds and insurers to manage interest rate and inflation risk inherent in their pension liabilities to South African pensioners and annuitants. Periods of high demand for long-dated linkers tend to co-incide with decisions by legacy defined benefit pensioner funds to increase their hedging of interest rate and inflation risk. Furthermore, a decision is typically made after a long period, often several years, of consultation and once made the decision applies to a significant quantum of assets and is typically implemented as quickly as market supply of linkers will permit. During these periods auctions are well supported with buyers striving to buy linkers in the market’s ‘normal’ trading size for fear of moving the market against them.

Adding to the view of significant support for this market is the fact that some of the country’s largest defined benefit pension funds are likely to continue to have an insatiable appetite for inflation-linked assets for many years into the future. These include the Government Employees Pension Fund and the Eskom Pension Fund both of which have significant liabilities to pensioners.

Current yields on inflation-linked bonds range between 1-2% p.a. above inflation but as little as 3 years ago the maximum yield on offer was 2.5% above inflation. Going even further back inflation-linked bond yields offered yields of north of 4% p.a. There has been a steady decline in yields as investors have come to realise the importance of owning an asset which offered guaranteed inflation protection even if the return was a somewhat unspectacular 2% above inflation. The ability to lock in this return for a long period, coupled with a somewhat muted outlook for equity returns, has only added to the appeal of inflation-linked bonds. Add into the mix an increasingly uncertain economic and political outlook and linkers become an asset of choice.

Some investors, those who hold a strong view about inflation potentially becoming un-anchored from the Reserve Bank’s 3-6% target range may even believe that linkers are a better investment than fixed rate bonds; the latter may not offer a real return above inflation in the event that inflation is persistently high.

But what about the contention that the outlook for inflation is muted and so the demand for inflation-proofed assets such as linkers will be limited? Liability-driven investors are typically driven considerations other than simply whether inflation is expected to be high or not. Their main objective is not to correctly call whether the outlook for inflation makes linkers a good buy or not. Rather they are driven by a need to avoid taking a bet on inflation. Linkers are a matching asset for the liability they have to pay their pensioners inflation-linked pensions. This means that holding assets with guaranteed inflation-linked returns is vital for proper risk management and offers certainty that they will be able to fulfil their obligations. Whilst they will still hold some investments that are expected (but not guaranteed) to offer inflation-beating returns over the long term, such as equities, the inclusion of linkers provides some protection should equities materially underperform inflation in the future.

Unfortunately, in some instances, the implementation of a large mandate to protect pensioner liabilities against high inflation sends a signal to the market that there is a large buyer in the market. This can cause the market to move against the buyer causing the market price of linkers to increase. Equally, when those buyers stay away from the market, demand quickly collapses with yields tending to rise. The SA inflation-linked bond market does tend to ‘self-correct’ in these situations; recent experience has been that once real yields spike above 2% due to a lack of demand, opportunistic buyers tend to re-engage. Furthermore many pension funds would appear to more comfortable with real yields that are above 2%; this level most likely being linked to assumptions made by pension fund actuaries when assessing pension fund liability values.

Demand for long-dated inflation-linked bonds, both in SA and across the world, is linked to the behaviour of the dominant investors in that part of the curve, viz insurers and pension funds. Comparing South Africa to the UK and the US, both the UK and the US long-dated inflation-linked bond markets bear similarities to the SA market in that all three are dominated by heavy buying from pension funds and insurers. We remain sanguine about the recent lack of demand; it is not unusual for the linker market to experience lulls and over the long-term there can be no doubt that buying interest will remain strong. Finally, all UK, and more than 90% of European, inflation-linked bonds offer negative real yields which in some cases are as low as -2%. A similar picture prevails across the Atlantic in the US. Are SA investors being too greedy given the uncertain economic outlook and SA linker real yields which offer them as much as a guaranteed +2% p.a. over and above inflation?