Wealth Manager

No wonder that the global market for inflation-linked
bonds is bubbling as well. Growing demand for hedging
inflation is one reason. But there’s the portfolio-diversification
angle, too. Investors increasingly see inflationprotected
obligations as a distinct asset class, even when
compared with conventional bonds.

As it happens, the supply of so-called linkers is rising,
too. More governments than ever are issuing inflationlinked
bonds. The global market capitalization for sovereign
inflation-linked bonds jumped 50 percent to $1.5
trillion in the two years through early 2008, according to
Barclays Capital.

The U.S. remains the biggest issuer, which translates
into roughly one-third of global market cap. That means
that most of the world’s linkers are floated offshore on a
value-weighted basis. It may surprise the casual observer to
learn that Brazil is ranked fourth in market cap for inflation-
linked bonds. According to a new global linkers bond
index from Barclays, 19 governments (including the U.S.)
are now issuing securities in this corner of the debt world.

In another sign that this sector of the bond market is
coming of age, the first ETF targeting the asset class has
been launched. State Street Global Advisors rolled out the
first international inflation-protected bond ETF in March:
SPDR DB International Government Inflation-Protected
Bond ETF (Amex: WIP), which tracks the DB Global Government
ex-US Inflation-Linked Bond Capped Index, a
benchmark of bonds from 18 developed and emerging
countries save for the U.S.

More global inflation-linked products may be coming, including
some based on the new Barclays Capital Universal Government
Inflation-Linked Bond Index. So says Ralph Segreti,
the London-based global inflation-linked product manager for
Barclays, which has been a leader in trading and analyzing linkers.
In a recent interview with Wealth Manager, Segreti discusses
the firm’s new benchmark, how it works and why investors
should consider inflation-linked bonds as something more than
a domestic asset class.

Q: What’s the rationale for the new Barclays Capital Universal
Government Inflation-Linked Bond Index?

A: This index allows you to get a truly diversified global allocation
and effectively buy the global real yield. It’s comprised of inflation-
linked bonds issued by sovereign debt issuers from a variety
of countries. So it’s a bond market index, not an inflation index.
It reflects price movements on the bonds and the underlying
real yield movements, as well as the inflation compensation
that’s paid.

The thought process behind the inflation index’s creation is
one of providing a new tool for investors as they look to globalize
their portfolios, increase diversification and search for higher
real yields.

In the 1990s, we started publishing inflation-linked bond
indices covering the main investment-grade sovereign issuers.
In the last couple of years, we’ve noticed a large increase in our
business in emerging market inflation. [The growth has come]
mainly from developed-market inflation investors looking for
alpha opportunities, a more diversified global basket, higher real
yields, greater exposure to things like food price inflation and so
on. Last year we created the emerging market inflation-linked
indices. Then, after consultation with investors, we decided that
what the market needed was a truly global, universal index. Our
new index provides the ability to invest in a globally diversified
portfolio of inflation-linked bonds, which hopefully captures
improved performance and diversification
benefits.

If you believe that the inflation pressures we’re seeing are a
global phenomenon, global allocations make sense. Indeed,
real yields recently have been considerably higher in a
number of other geographies [relative to the U.S.].

Q: Nominal yields certainly vary in markets around the world.
Do real yields differ on a global basis as well?

A: They’re not similar, and there isn’t a global real yield. The
markets haven’t converged in that sense. So, there’s a
divergence [in real yields], which creates relative
value and alpha opportunities, and that’s one reason why
people are looking for global portfolios.

Q: Is it fair to say that another reason that real yields vary is
because monetary policies and economic cycles differ from
country to country, and the divergence is reflected in a range of
real yields?

A: Exactly. For example, in the U.S. people are worried about the
possibility of recession and an incredibly accommodative Federal
Reserve, while in Europe, the ECB isn’t as accommodative.

Q: What countries does your index cover?

A: It encompasses the developed countries—all the G7 countries
are in there, as well as a few others like Sweden and Australia,
along with emerging markets. Overall, our universal index reflects
a diversified global basket of inflation-linked bonds.

Q: What is the weighting strategy for the index?

A: It’s market capitalization weighted. Market cap here means
the outstanding amount of total market value. If you have a
bond issued at par, and it’s trading at 110 with a billion dollars
of the bond trading, market cap is $1.1 billion. So market performance
definitely figures into the calculation. Overall, the
index’s total market capitalization is about $1.5 trillion.

Q: Who are the leading sovereign issuers of inflation-linked
bonds in the world?

A: The U.S. is the largest issuer with a roughly one-third weighting
in the index. The U.K. is second with about 20 percent;
France is third at about 14 percent, followed by Brazil at
around 9 percent. It trails off to Italy, Japan, Canada, Sweden,
Germany, Argentina and on down.

We also have versions [of the index] that cap the U.S. at 25
percent. In fact, we can customize the index any which way. For
example, some investors might want an ex-U.S. version if they
already have TIPS. We can slice and dice as you want.

Q: How does your new index compare to global inflation proper?

A: It depends on how you measure global inflation. For instance,
many people are concerned about the BRICs—Brazil, Russia,
India and China. The only BRIC representative in the index
is Brazil, and it has a reasonably high weighting. If you look
at Asia, which a lot of people target, you have Japan, Australia
and South Korea [inflation linkers]. But you’re not getting a
full and complete picture [of inflation with the index]. Instead,
you’re getting a complete picture of the marketable securities
that are available from the governments that have chosen to
issue inflation-linked bonds.

Q: How might the index change if more countries
start issuing inflation-linked bonds?

A: Our indices are designed so that if India,
Russia and China come on board and start issuing inflation-
linked debt, they easily will fall into the index. It’s a rules-based
index, so it’s likely that [new bonds from those countries will] \drop in
once you get sufficient size issuance. There were press reports
a few years ago of India looking [at the inflation-linked bond
market]. Russia said it’s probably not going to do anything
for a few years. But over time we’d like to see the larger global
economies all issue inflation-linked bonds, and when that
happens, they’ll be added to the index.

Q: It’s clear why investors buy inflation-linked bonds—hedging
against higher inflation, for instance. What is a government’s
motivation for issuing inflation-linked bonds?

A: There are several incentives. First, it broadens the investor base
and lowers your overall cost of debt financing. When you issue
inflation linked bonds, you draw in more international capital.
It also lends more credibility to your monetary policy because
it sends a signal to the broader world that you’re serious about
containing inflation. If you’re issuing inflation-linked debt,
it’s more difficult to inflate your way out of problems, and
so issuing the bonds lends credence to your monetary policy
aims. It also allows for better monetary policy decision-making
because it generates market-based expectations of future inflation.
People are actually putting money down on inflation expectations
[when they buy inflation-linked bonds]. And that’s
believed to be more reliable than just surveys or forecasts [for
predicting inflation]. The Federal Reserve and the European
Central Bank use inflation-linked bond markets for expectations
of future inflation, which then gets channeled into the
monetary policy decision-making process.

Q: An ETF has already been launched on a competing global inflation-
linked bond index. Will the Barclays index also become
the basis for creating securities?

A: Yes. This, too, is an index that can be used for creating mutual
funds, ETFs and other products benchmarked to it. We’re
going to bring out products and distribute them via our institutional
sales force as well as through the private bank channels
to high-net-worth individuals. We’re also talking to asset
managers, ETF managers—we’re looking for things like mutual
funds and other products that will make the index more
broadly available.

Q: Is there a Barclays iShares ETF linked to your inflation-linked
bond index on the horizon?

A: That’s [a decision for] Barclays Global Investors. Although we
have the same owner, that’s not us [Barclays Capital]. I will say
that ETF products are proving quite attractive and successful,
and I’d like see ETFs and mutual funds launched based on the
index at some point.