Achieve diversification and return potential within an inflation-hedge basket.
U.S. institutional investors are exploring investments in strategies that hedge against the risk of rising inflation in an environment of expansionary monetary policy. These strategies often consist of investments in inflation-protected securities such as U.S. Treasury Inflation-Protected Securities (TIPS) as well as real estate and commodities. Emerging markets inflation-linked bonds (or “linkers,” as they are often referred to) can provide investors with diversified sources of inflation protection and return.
Why Emerging Markets Linkers?
- Provide a hedge against global inflation
- Structurally higher inflation in the emerging markets than in developed markets
- Typically higher real yields than developed markets on average
- Increased portfolio diversification since correlations to other asset classes are low
- Greater opportunities to find value in emerging markets linkers as real yields and currency impact vary significantly
Where Do They Fit?
- Dedicated emerging markets linkers mandate
- Component of a broader global inflation-hedge program
- Part of emerging markets debt mandate or multi-asset strategy
The Many Benefits of Emerging Markets Linkers
Global investors seeking ways to hedge against inflation have become more interested in a broad set of inflation-linked bond strategies in recent years. The low correlation between emerging markets linkers and other asset classes is an attractive feature of inflation-linked bonds in the developing world. Real yields in developing markets also tend to be higher than those in the developed world, offering considerable opportunities to find value in emerging markets linkers.
Emerging markets generally experience higher structural inflation than developed markets. Inflationary pressures vary by country in the emerging markets given differences in each country’s economic architecture and the composition of its CPI basket. Interest rates in the developing world are also subject to an array of central bank policies. This provides investors with numerous opportunities to add value via linkers.
Given that inflation-linked bonds in the emerging markets are denominated in local currencies, the currency component of return can provide additional diversification. The currency component can cut both ways, either adding or detracting from returns. While inflation can influence currency movements, emerging markets currencies are driven by a number of idiosyncratic factors. As a result, we think that actively managed currency exposure presents another opportunity to add value.
More broadly, we believe it makes sense to take an active approach to investing in inflation-linked bonds, and consider the relative value of linker markets on a global basis. We offer several strategies for investors to access opportunities in inflation-linked debt around the world.
No Longer a Niche Asset Class
Several developed economies have mature inflation-linked bond markets, with the U.S. and the U.K. being the most prominent. Emerging markets governments started issuing linkers following the debt and currency crises of the 1990s in an effort to obtain funding at reasonable rates and rebuild investor confidence in the effectiveness of their anti-inflation monetary and fiscal policies. Establishing a broad-based linkers program sent a strong message about a regime’s commitment to those policies: fiscal liabilities would not be simply “inflated away.”
Exhibit 1: Emerging Markets Linkers Have Continued to Grow as an Asset Class.
This was particularly important in markets with a history of severe inflationary cycles, such as Brazil. Governments proceeded on the assumption that successful economic policies would help keep inflation under control over time, ultimately reducing debt service costs.
Inflation-linked bond markets in the developing world have continued to grow in recent decades as governments have committed themselves to inflation-linked bond issuance and the development of full yield curves. In the last 10 years, the size of this market has grown from about $20 billion to more than $500 billion (Exhibit 1). No longer a niche asset class, inflation-linked bonds have become a critical part of world bond markets and an important element of any well-diversified bond program.
The Bloomberg Barclays Emerging Markets Government Inflation-Linked Bond Index (EMGILB) includes bonds from 11 countries. (The Bloomberg Barclays index excludes some issuers that do not meet liquidity requirements, such as Uruguay.) Brazil, which began issuing linkers in the 1960s, is the largest issuer in the emerging markets by far, making up more than half the index.
Other countries such as Mexico, South Africa and Turkey also have fully established inflation-linked bond funding programs with complete yield curves. The Bloomberg Barclays Emerging Markets Tradable Government Inflation-Linked Bond Index (EMTIL) is less heavily weighted toward Latin America as it caps large countries at a maximum weight of 25% in the index and does not include bonds issued by Colombia and Argentina. It also allocates a minimum exposure of 5% to smaller countries.
Structural Inflation in the Emerging Markets
There is a strong case for investing in emerging markets linkers based on structural inflation in the developing world. As economic conditions improve in the emerging markets, living standards rise and so do prices for goods and services. At the same time, global economic shifts can cause commodity and food prices to fluctuate. Even shifts in weather patterns can have an impact. Emerging markets’ CPI baskets have much higher weightings in commodities and food products, and tend to experience inflationary pressures before they affect the U.S. or Europe. As a result, by owning emerging markets linkers at the right stage, investors can benefit from the resulting inflation accrual.
Inflation-linked bonds compensate bond holders for the loss of purchasing power due to inflation. The mechanics of U.S. TIPS tend to be a good example of how inflation-linked bonds generally function. The principal is adjusted for changes in inflation as measured by the Consumer Price Index. The index-adjusted principal is then used to calculate the coupon to be paid. For example, if a TIPS bond is issued with a par value of $100 and one year later CPI has increased by 3%, then the par value of that bond is adjusted to $103 and the coupon is computed based on that value. This adjusted principal value then becomes the value the investor would receive if the bond matured at the end of the year. While inflation accrual dynamics differ by market, the same broad principle applies to emerging markets linkers.
Despite periods of volatility associated with the currency crises of the 1990s, real exchange rates in the emerging markets economies have tended to appreciate over the last decade, largely due to the impact of structural reforms. This appreciation has taken place through a combination of a rise in nominal exchange rates as well as an increase in domestic price levels. Linkers allow the investor to capture returns from both sources.
Higher Real Yields in the Emerging Markets
Inflation-linked bond returns are driven by two main components: inflation accrual and real yields. (Real yields do not take inflation into account.) Both real yields and inflation rates in the developing markets can vary quite dramatically, providing investors with considerable opportunities to add value (Exhibit 2). On average, real yields in the emerging markets are meaningfully higher than those in the developed markets: As of March 31, 2013, the average real yield of the World Government Inflation-Linked Bond Index (WGILB) was –0.38%, with many countries offering negative real yields. In comparison, the average real yield of the EMGILB was 3.18%. Several developing markets offer yields in the high single digits after the expected inflation accrual is added to the real yield.
Exhibit 2: Inflationary Pressures in Emerging Markets Offer Opportunities.
Low Correlations: Emerging Markets Linkers Provide Diversification Benefits
For investors seeking a hedge against inflation and broad investment diversification, this is an asset class with attractive characteristics. Emerging markets linkers have traditionally shown a low correlation with other assets such as U.S. Treasuries and TIPS, making them suitable for an inflation-hedge bucket within an asset allocation program (Exhibit 3). Equities have historically provided some protection against inflation. However, they are not an explicit hedge and their returns are driven by a number of additional factors. A dedicated emerging markets linkers mandate can serve as an extension of a broader global inflation-linked bond program and may offer an attractive yield pick-up when real yields and inflation accruals are low for developed-market government bonds.
We recommend the Bloomberg Barclays EMTIL as a benchmark for emerging markets linker strategies because it is a more balanced index than the EMGILB.
Real yields have fallen significantly across a number of markets in the wake of the financial crisis. Although the asset class still offers attractive relative value, the lower absolute level of real yields indicates that expected returns may also be lower than those in recent years. At the same time, there is wide variation in valuations across the emerging markets linkers universe, providing active managers with additional opportunities to improve relative returns.
Exhibit 3: Correlations Between Emerging Markets Linkers and Other Assets Are Low, Providing the Opportunity for Greater Diversification.
Monthly Return Correlations for the Six-Year Period Ended March 31, 2013
Bloomberg Barclays EMTIL
U.S. CPI Inflation
Comparing Emerging Markets Linkers With Developed-Market Inflation-Linked Bonds
Emerging markets linkers generally look more attractive than those in the developed world right now, since real yields for developed-market linkers are largely negative. While inflationary pressures are a primary driver of linker returns, real yields are another major component. The fall in a bond market’s real yields can drive returns. It’s important to look closely at specific markets, since real yields and inflationary pressures can differ quite significantly across emerging markets.
For example, Turkey issued its first inflation-linked bond in 2007. By May 2008, Turkish bonds had a real yield of 11%; today those yields have come down to less than 1.5%. So it’s been a fabulous investment given the combination of high real yields and inflation. Turkish inflation could still be as much as 8%–9% in the near term and 6%–7% over the medium term, so — even though real yields have come down significantly — there is still considerable potential for substantial linker returns.
Brazil, which has some of the highest real yields in the emerging markets, is another example. They’ve come down considerably in recent years but still rank among some of the highest in the world. Inflationary pressures are also rising in Brazil. That, combined with a 3%–4% real yield, offers the potential for a 10% return in Brazilian linkers. The quality of the return is lower than we’ve seen in the past, but it is nonetheless still attractive.
The great thing is that investors can access inflation-linked bonds in a dedicated strategy, as part of a broader emerging markets debt mandate, or via a global inflation-hedge program. Emerging markets linkers can be an excellent diversifier given how low correlations are to other asset classes. They can push out the efficient frontier in a U.S. inflation-linked portfolio, for example, by improving both its risk and return characteristics.
Capital has been investing in inflation-linked bonds for two decades. We made our first investments in U.K. linkers in July 1993 and in U.S. TIPS in January 1997, when they were first issued. Inflation-linked bonds have composed almost 20% of holdings in our emerging markets debt portfolios over the past year, and we currently hold linkers from a number of emerging markets across several mandates. We have made substantial investments in markets such as Brazil and Turkey, where real rates are high.
Our decision to invest in linkers from a particular country is made only after fundamental economic and political analysis and an assessment as to whether they represent good value at that point in the market and inflation cycles. We believe it is important to be comfortable with the underlying country risk before considering whether to take exposure via the nominal or linker bond market. This is also applicable to currencies, which are affected by both local and global factors, and where the cost of hedging can be significant in some cases.
Constructing a Linkers Portfolio
Our portfolio construction process combines both a structural and a tactical approach. In general, we take structural positions on the basis of the medium-term outlook for real yields. Tactical positions are driven by our near-term view of the rate of inflation accrual in a given market. The primary drivers for the portfolio construction process include:
Real Yield Relative Value
Macroeconomic considerations such as relative GDP growth, fiscal and monetary policies, and country credit ratings are key factors in determining the appropriate level of real yields in individual markets.
Understanding local currency markets is a major factor in analyzing investments in emerging markets linkers. Currency appreciation can amplify returns in local currency–based inflation-linked bond investments, but currency depreciation can erode returns. In addition, while rising inflation enhances inflation-linked bond returns, higher inflation can lead to currency depreciation, thus weighing on the total return. Managers can and do hedge currencies in inflation-linked bond investments when they believe it might be beneficial.
Inflation accrual tends to follow distinct patterns in each market. This gives rise to tactical opportunities to switch between markets in order to benefit from the highest levels of inflation accrual. In an environment of rising food and energy prices, it is important to identify those countries whose CPI basket has a heavy weighting in those commodities.
Use of Nominal Bonds
There will be periods when inflation accrual is simply too weak to make it attractive to hold linkers in a particular market. Apart from switching out of such markets and into those with stronger inflation accrual, it may also be advantageous to temporarily switch into nominal bonds in broader emerging markets debt mandates. This tactic can also prevent large swings in the portfolio’s currency exposure.
A linker’s valuation can become misaligned with its fundamentals. Linkers may be the only available liquid instruments, or local pension funds may suddenly become more active in the market, or market participants may use them to take a view on the currency. Valuation discipline and experience investing in linkers are both important.
In conclusion, emerging markets linkers have evolved into a dynamic and significant segment of the bond market in recent years. Capital offers clients a variety of strategies to gain exposure to emerging markets inflation-linked bonds: as a dedicated emerging markets linkers mandate in an inflation-hedging program; as part of an emerging markets debt mandate; or within a total return mandate such as our Emerging Markets Total Opportunities (ETOP) strategy. There are a variety of factors involved in investing in linkers, including top-down macroeconomic analysis, bottom-up credit selection, valuation discipline and potential currency hedging. We believe that our substantial experience in emerging markets bond investing and integrated global resources make us particularly well suited to investing in this area.