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Career opportunities – the ones that never knock. With youth unemployment rising steadily in the UK, where are the protest songs?

“Wham, bam – I am, a man
Job or no job, you can’t tell me that I’m not.

Hey everybody take a look at me
I’ve got street credibility
I may not have a job but I have a good time
With the boys that I meet down on the line.”

“Wham Rap” by Wham!, 1982

My mate told me recently that the first Wham! album was surprisingly good, so I bought it.  It is good, and I am surprised.  I was also surprised to find how political songs like Wham Rap were, and it got me thinking about writing a blog about the political songs that made the charts in the 1980s in response to the recession, and wondering why today’s youth haven’t written any.  After all, youth unemployment is famously high isn’t it?

The data only go back to 1983 for youth unemployment – but you can see that the early 80s were a time of youth unemployment rates of nearly 20%.  In 1981 we had songs like Ghost Town by the Specials, 1 in 10 by UB40 (the band itself named after the dole claim form), Shipbuilding by Elvis Costello in 1982, and by 1985 Frankie Goes to Hollywood were selling T-Shirts saying “Frankie Say Arm the Unemployed” and leading a delegation to Downing Street to deliver a petition against the axeing of benefits for school leavers if they didn’t go onto a Youth Training Scheme (YTS).  It was signed by Paul Weller, Madness, Smiley Culture, the Flying Pickets (another politically relevant name inspired by the miners’ strike) and Alison Moyet.

Some argue that the youth unemployment numbers are distorted (this post on the website Straight Statistics says that the treatment of youths in education is a distorting factor, and that the outright number of young people claiming unemployment benefits is little different than it was in the early 1990s, although it was high then too).  Nevertheless there are 1.7 million people between the ages of 18 and 24 who are economically inactive (of which 0.7 million are officially unemployed, the remainder are largely in education).  If anything, with free tertiary education a thing of the past (although with access to that education easier) the kids of today have even more to be aggrieved about – those going to university are being saddled with debts of tens of thousands of pounds.  And never before has the technology to make music (or indeed film) been so cheap and available.  I’ve a grand piano, a drum machine, and an 8 track recording studio on my mobile phone.  Maybe you can only be a protest singer if you have an acoustic guitar.  Incidentally whilst thinking about this issue I stumbled across an article on the BBC website, by an American writer wondering where the great US cultural response to the Great Financial Crisis is.  Perhaps, he speculates, the safety net is greater than it once was, and the starting point for living standards higher thanks to multi-income families?

Perhaps though there are protest songs out there but I’m missing them?  Let me know.

On an unrelated note, I was in Ireland seeing clients earlier this week – one recommended I read this article by Morgan Kelly, a notorious economics professor at University College Dublin, from Saturday’s Irish Times.  In it he claims that the Central Bank governor Patrick Hononhan’s decision to keep a government guarantee on Irish bank bonds was “the costliest mistake ever made by an Irish person”.  He says that the only way to avoid an Irish sovereign bond default is to effectively default on the ECB loans made to the Irish banking sector, halving Ireland’s debt to Euro 110 billion.  He also thinks government borrowing needs to fall to zero.  Neither of these outcomes looks likely – Irish CDS currently trades at 640 bps and there is open talk about default being both acceptable and even desirable.  The mood is relentlessly gloomy in Dublin – our taxi driver told us that his firm now hires him out at a daily rate of Euro 200 compared with Euro 440 a couple of years ago.  There’s no shortage of taxis – it’s a service where demand collapses simultaneously with a dramatic increase in supply as people try to earn an extra income.

Finally, and totally unrelated to bond markets or economics, the film How to Lose Friends and Alienate People was on TV earlier this week.  This is the story of Toby Young (who is trying to set up a Free School near where I live in Hammersmith – don’t get me started…) and his disastrous time on the staff of Vanity Fair in New York working for the famous editor Graydon Carter.  It reminded me that I read the book when it first came out, and finished it on a plane.  I’d never heard of Graydon Carter before, but as I disembarked the man in front of me’s tennis racket case dangled in my face revealing a business card tag stating “Graydon Carter, Vanity Fair”.  What are the chances of that?  Then I realised that whilst for me, the chances of being on a flight with him were minutely small, the chance of Graydon Carter being on the same flight as somebody reading that newly published book were probably evens or better.

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Borrowing costs (or κόστος δανεισμού if you’re Greek)

Following on from last week’s ECB press conference, on Wednesday this week we had the quarterly Bank of England Inflation Report. Amongst the questions asked at the press conference were a couple on the serious issue of the stability and future of the Eurozone. Mervyn King refused to be drawn into commenting though, saying that “the problems are very difficult, they are very challenging, and I don’t want to make life more difficult by making any public comment that could conceivably make it more difficult for those charged to deal with it”. In one extreme he may have feared his words would be twisted to weaken the Eurozone financial system, or at the other extreme, if he were to speak the plain truth he would undermine the system.

In its report, the Bank of England focused on the attached chart as one of the reasons why they had maintained the bank rate at such a low rate of 0.5%.  The chart tries to create a proxy for the real cost of borrowing for the wider economy by taking 3-month libor and adding on a proxy for bank cost of bank funding (CDS).  It illustrates that the official bank rate of 0.5% is equivalent to an official rate of 2% in the pre credit crunch world.  The transmission mechanism between the official Bank of England ‘Bank Rate’ and the real price and availability of credit to the wider economy has dramatically altered.  We are still in a credit crunch. 

Bank of England's estimate of marginal funding cost

Let’s use this analysis and apply it to the Eurozone economy that Mervyn King refused to discuss.   We’ve taken the biggest banks in each of Ireland, Greece and Portugal and added CDS to 3-month Euribor, where each bank is weighted equally within each country. The financial crash and the Eurozone sovereign debt crisis has meant that the cost of money has changed dramatically for these countries.   There is not a single market  interest rate in the single market.  The true interest rate for peripheral Europe is very high, and is not exactly encouraging for growth in these countries.   The Eurozone has a single official cost of financing set by the European Central Bank, but the cost of money varies dramatically between nation states and their banks. 

The real cost of funding in perhiperal Eurozone

In order to attempt to offset this effect, the ECB has been forced to intervene by funding the peripheral banks itself in return for collateral.  This helps mitigate the problem but exposes the ECB to risk.  The chart shows the problems these peripheral economies face in terms of a functioning financial system, and the huge task the ECB faces in implementing appropriate monetary policy for the Eurozone. No wonder the Bank of England does not want to comment directly on the problems the Eurozone faces.


So we’re all being financially repressed in the developed world – but does that really mean poor bond returns? (+ competition time)

I attended an interesting lecture last year by Carmen Reinhart (hosted by RBC) where she predicted an era of negative real returns for investors in developed market sovereign bonds.  This was due to what she termed ‘financial repression’, as the authorities in richer countries struggle with the huge debt burden.  Financial repression is loosely taken to be things such as greater financial regulation, capital controls designed to limit capital flows, restrictions on competition in the financial sector, credit restrictions, higher bank reserve requirements, enforced liquidity ratios (so banks must hold a minimum of their reserves in government bonds), pension fund legislation forcing pensions to own more domestic sovereign debt, or caps on deposit rates. The consequence of financial repression is that nominal sovereign bond yields are artificially depressed for a prolonged period of time, and domestic investors therefore experience low or negative real returns.

Reinhart and Sbrancia have since elaborated on these thoughts (see here), where they argue that financial repression is a subtle form of debt restructuring and is a policy that had significant success in reducing government debt burdens post the Second World War. Far from being a modern phenomenon or one confined solely to emerging markets, they find that real interest rates in advanced economies  were negative about half the time between 1945 and 1980, and ‘for the United States and the United Kingdom, the annual liquidation of debt via negative real interest rates amounted to 3 to 4 percent of GDP on average per year.  Such annual deficit reduction quickly accumulates (even without any compounding) to a 30-40 percent of GDP debt reduction in the course of a decade.’

Many investors and commentators point to negative real yields today as a reason why government bonds are unattractive (see here for a sensationalist write-up on negative real yields in the US for example).  Real yields are indeed exceptionally low right now.  Take index-linked gilts for example – real yields on the 2.5% 2013s are -2.1%, which means that if you purchase this security and hold to maturity then you are guaranteed to underperform UK RPI inflation by an annualised 2.1%.  In the UK, you have to go down the yield curve to 2020 before you have a positive real yield.  The same can be seen in US TIPS, where the 0.625% 2013 has a real yield of -1.8%, although European real yields are a bit higher (the German 2013 inflation linked government bond has a real yield of -0.2%,  a reflection of lower anticipated inflation rates and a reflection of the ECB’s decision to hike nominal interest rates in the face of a perceived inflation shock).

PIMCO’s Bill  Gross also highlighted Reinhart and Sbrancia’s paper in his recent investment outlook, and used this argument to explain why investors in developed market government bonds are being short changed.  But I think he misses out on a very important point*, which is all to do with the shape of the yield curve.  Let me explain. 

Yield curves in the UK and the US in particular are exceptionally steep.  Looking at the UK,  the MPC’s decision to keep the bank rate at 0.5% is keeping the front end of the gilt market very well anchored.  Short dated gilts are also being supported by heavy buying from relatively price insensitive central banks (all these FX reserves from around the world have to go somewhere – the Economist had an interesting take on this topic recently here).  The yield on the UKT 4.5% Mar 2013 is just 1.0%, which isn’t particularly enticing.

However, once you go out a few years, the gilt yield curve starts steepening sharply and gilts look more interesting.  The UKT 2% 2016 has a yield of 2.2%, while the UKT 3.75% 2021 has a yield of 3.5%.  Many argue that an average annualised 2.2% total return for a five year gilt held to maturity is hardly a screaming buy, and nor is a 3.5% annual return from a 10 year gilt.  But you also need to consider the effect of what’s called the ‘roll down’.  This means that what is currently a five year gilt yielding 2.2% will ‘roll down’ the yield curve and will become a three year gilt yielding just over 1% in a couple of years, if you make the assumption that the yield curve remains exactly the same shape.  And as we all know, when bond yields fall, prices rise.

So if the yield curve stays the same shape, then the drop in the gilt’s yield as it rolls down the curve will result in a capital gain on top of the income received from the gilt.   To demonstrate this, firstly consider the UKT 4.5% 2013, which matures in March 2013.  The yield on this gilt is currently 1.0%, so an investor buying this today will have had a total return of 1.0%pa at maturity.  Not great.  But assuming the yield curve doesn’t change shape between now and March 2013, the UKT 2% 2016 will have a yield of 1.4% in a bit under two years, so as well as clipping the 2% coupon each year, you’d also get a capital gain of 1.3%pa, providing a total return of 3.3%pa.   This is a very important difference as a 3.3% annual return (coupon plus capital gain) is considerably more attractive than 2.2% (the bond’s current yield).   In fact,  the UK bond market’s five year inflation expectations for the RPI measure is 2.8%pa, which equates to inflation expectations of roughly 2%pa for CPI.  If the UK yield curve remains the same shape, then the UKT 2% 2016 would give a return 1.3% in excess of current inflation expectations.  

Using the same yield curve assumption, by March 2013 the UKT 3.75% 2021 will have shortened from being a ten year gilt to an eight year gilt, and its yield will have fallen from 3.5% to just above 3.2%.    The income from the gilt plus the capital gain as the yield falls would give you a total return of about 4.7%pa over the next couple of years, which is again significantly above the headline yield of 3.5%, providing a decent positive real return.  

Therefore, if you believe that the yield curve will remain steep and short rates will remain anchored (perhaps due to the massive public and private sector debt burdens, the vulnerable housing market and UK banking system, the likelihood of lower inflation next year, and the fact the UK economy is no bigger than it was six months ago), then you’d likely see government bond returns in excess of inflation, at least in the 5-10 year maturities where the yield curve’s still steep.  Of course, if your view is that the Bank of England or Federal Reserve will start hiking rates then you’ll have a different view about the future shape of the yield curve and therefore the attractiveness of government bonds.  Indeed, the market is pricing in a normalising of interest rates (there are two 0.25% rate hikes priced into the UK bond market by this time next year) and the ‘no arbitrage’ rule dictates that the yield curve is expected to steadily flatten over the next few years.  But we disagree with what the market’s pricing in – we think rates will stay lower for longer, and the yield curve will remain steep.  Given this view, the roll down effect illustrates why we’re uncomfortable getting too short duration, and most of the funds we manage are either marginally short duration or neutral.   It’s expensive to be very short duration right now.

Congratulations if you’re still with me; here is your reward.  Carmen Reinhart signed a copy of This Time is Different for me when I met her last year, and it’s such a good book that we’ve previously offered it to readers on this blog.   The person who is closest to guessing where Spain 5y CDS is at the close of Tuesday 31st May wins (we’re taking the GCDS page on Bloomberg).  To give you a guide, it briefly exceeded 350bps at the beginning of this year before rallying to below 200bps at the beginning of April, but continuing Eurozone sovereign debt fears have meant it’s since widened to back above 250bps.
Click here to email your entry. Click here to read and print off competition terms and conditions. All entries to be received by midnight Friday 13th May.  The information we collect from you is used solely to contact you in the event that you have won and the winners name may be publicised.

*  Note that it’s not the first time that we’ve disagreed with Bill Gross – see Richard’s response to PIMCO’s ‘bed of nitroglycerine’ comments here


ECB, ‘No problem’

As fund managers we sift through a huge amount of information, in the desire for finding good and avoiding bad investments. Writing these blogs entails a further distilling of these ideas into a single point.

One of the things we do regularly is to listen to the ECB press conference, held following their rate decision. Most of this is the usual mix of diplomatic, repetitive, and instructive dialogue you would expect to hear.
What we look for beyond this is the subtext, the trend, or the offguard comment. Occasionally we get something different. This is when a question penetrates the cool facade and the answer given reveals the real issues.

Such an event occurred this week. One journalist asked if the ECB was concerned about having a balance sheet containing Greek and other sovereign debt that might not be money good. A good question. The answer came back short and sweet from Trichet, “No problem”.

No problem

Usually an economist would happily expound on this and explain why it was no problem. Instead he moved swiftly on.

Now either it is simply at one extreme no problem and so obvious the question was plainly beyond contempt, or at the other extreme something that needs to be swept under the carpet.

No problem

Don’t think so.


Has German growth peaked?

Just as the ECB has started tightening monetary policy, and just as the sovereign debt crisis appears to be coming to a head (don’t rule out a Greek restructuring over this long weekend although it remains an outside chance), it feels like we might have seen the best of German growth for this cycle. 

The chart below (from UniCredit via Bloomberg) shows that cargo volumes at Frankfurt Airport have fallen substantially from their peak, and are now down year on year.  This series has been a good lead indicator for export growth (which was running at a stunning 18.5% in 2010), which itself was a big driver for Germany’s above trend GDP growth rate of 3.6% last year.

German exports look likely to fall

Fraport, the airport operator, has said that the disruption to the global supply chain following the Japan earthquake was to blame for the volume falls – but the drop also coincides with a period of a considerable strengthening of the Euro.  On a trade weighted basis the currency is up over 7% from its low in January.

Euro has strengthened considerably

I’ve seen research recently that’s claimed that Germany, with a “high margin big ticket” exporting focus is less impacted by a strengthening currency than, say, Portugal which exports lower value added, low margin goods (e.g. leather bags) – if that is the case the periphery must be really suffering with the Euro strength.

This morning we had a second monthly fall in German business confidence (the IFO index), although the outright level is still relatively strong.  Nevertheless, whilst the ECB rhetoric is about inflation fighting and tighter monetary policy, the Euro can stay strong – and that’s going to hurt Germany.


Where are we now? Some wise words from the IMF

Yesterday I attended a lunch with two senior IMF officials (hosted by Morgan Stanley), which came on the back of a number of excellent recent publications from the Fund (the speakers drew heavily from the Global Financial Stability Report, but it’s also worth having a look at the World Economic Outlook and Fiscal Monitor).

Financial stability has generally improved over the last half year, but numerous vulnerabilities and challenges remain.  The biggest medium term risk for developed countries was deemed to be the fiscal situation in the US and Japan.  The US in particular is showing little appetite to reduce fiscal deficits or government debt levels.  US gross government debt levels are approaching a concerning 100%, about 43% of what the US government spends is financed by borrowing, and yet the political parties are struggling to agree on the right course of government action.  Special interest groups are having more and more political power, making it harder to increase taxes or reduce government spending.  A build up in public debt means that the US and Japan are becoming increasingly vulnerable to a rate shock, with the US having an average debt funding cost approaching 10% of tax revenue, a level that Moody’s have previously suggested puts the US credit rating at risk.  As debt levels increase, the danger is that it requires a smaller and smaller increase in bond yields before debt interest costs hit 20% of tax revenues (in the US this is when the average borrowing cost is above 6%, but in Japan this has fallen to a little over 4%).  The US is driving closer and closer to the cliff edge, testing when investor confidence is going to break. 

One of the biggest short terms risks is unsurprisingly the Eurozone debt crisis, where funding costs need to be reduced and more clarity needed on EFSF/ESM support and the debt restructuring mechanism.  This is especially urgent given that the political will for further austerity and bailouts is likely to wane, with current elections in Finland an interesting barometer.  In terms of the likelihood of sovereign debt restructuring, an interesting discussion point around the table was that if the market starts to view Spain as ‘safe’ and Spanish sovereign spreads tighten, then the likelihood of a sovereign restructuring at some stage in Greece actually increases since the authorities would deem it very unlikely that a Greek restructuring would result in a European ‘Lehmans event’.  However, if Spanish sovereign creditworthiness comes under pressure,  then the likelihood of a Greek restructuring taking place would most likely fall, since the risk of contagion from a Greek restructuring to other sovereigns would be seen as too great. 

It’s not just the governments that are struggling to reduce leverage.  Households need to reduce debt too, with mortgage debt forming 75% of US household debt, and US household debt is already 91% of US GDP (the UK’s household debt is in fact higher still, at 107% of UK GDP).  More principal writedowns by banks are needed, and the large debt overhang poses further downside risks to housing markets. 

Finally, in terms of emerging markets, capital flows have accelerated and this is causing policy dilemmas for a number of emerging market countries.  Some nations (namely China, India and Turkey, but also some countries in Latin America) are experiencing worrying private credit growth rates, and authorities need to allow their currencies to appreciate to prevent overheating and the build-up of financial imbalances.  While emerging markets do not look like they’re about to pop, there are warning signs of bubbles developing.  


Icelandic geysers say “No”

Last weekend the voters of Iceland said no to honouring claims made against their nation by the British and Dutch governments. These claims originate from the failure of “IceSave” saving accounts. Many depositors in these accounts were based in the UK and Holland. In the wake of the funding crisis the UK and Dutch governments  covered the losses of their respective citizens.

The Icelandics are faced with a dilemma. Do they choose the cheap short-term option of walking away from their debt, or the expensive short-term option of paying up? If they choose the latter, then Iceland will probably garner greater support in terms of future potential borrowing, and a higher possibility of joining the EU club.

It is likely that the next stage of the IceSave process will be in court, and this shows the dilemma of lending to a state as opposed to a corporation. Even if the court rules against Iceland, how will the UK and Dutch governments recover their money? Default risk is lower in sovereign credits than corporates, but recovery is often at the whim of the electorate, and rightly so. Most sovereign states have the benefit of democratic constitutions. When lending to a corporation it is the probability of default and recovery potential that investors have to focus on. When lending to a sovereign it is the willingness and ability of the citizens to repay debt that investors have to focus on.

The claim from the UK and the Dutch is a result of them bowing to their own electorate who had invested with Icelandic institutions, and they were given their money back in full, despite the deposit protection scheme being well publicised. In this case, we have the bizarre situation where a company operating outside its national boundaries has defaulted, the voting members of the sovereign state they operate in get bailed out, and the claim is passed onto another state, whose electorate (not surprisingly) do not wish to pay.

The Icelandic voters have decided they did not want to bail out the UK and Dutch governments, who had bailed out their own voters. Given the structure of the Eurozone banking system, one currency, hugely mobile capital, and a multitude of democracies, Iceland could well be a test case of what happens next (see previous blog on Iceland here). Financial integration without political integration may plain and simply will not work.


Japan and inflation expectations; and velocipedes

A couple of months ago I mentioned the Billion Prices Project - a daily CPI estimator which collects online prices to construct an index which we can compare with the official inflation releases. Sadly there is still no UK measure, but a month after the Japan earthquake and tsunami we can see what appears to be happening there. It looks like there was an intial inflationary shock, but prices have since fallen back again. Another index they produce is the Product Availability index (page down on the previous link); this shows that from a pre-quake base of 100%, only 85% of goods are currently available, reflecting broken supply chains.

Because the BPP looks at online prices only, it is possible that food is under-represented (the methodology detailed on the website is pretty sparse) relative to, say, DVDs and clothing. So the fall back in inflation in recent days might be reflecting discounting as retailers start to suffer. Bond markets however have priced in a significant increase in inflationary expectations. The Japanese inflation linked bond (JGBi) market has stalled in development for some time now – they had always been pretty illiquid, and the longest bond outstanding is now under 8 years to maturity. Perhaps this isn’t surprising in a world where the Nationwide CPI measure has been negative for most of the last 13 years! Looking at breakeven inflation rates as priced by the JGBi market (see below) however, you can see that there has been an upward trend in expected inflation since the depths of the Great Financial Crisis in 2008, and most recently, since the earthquake, the 8 year breakeven rate has increased from minus 0.4% (i.e. deflation on average over the next 8 years) to zero. The Bank of Japan announced a 10 trillion yen increase in quantitative easing following the disaster, and it’s probably this that has lead to higher inflation expectations amongst investors (although the BOJ’s previous attempts at QE had very little impact on inflation or the economy).

Elsewhere on the BPP site you can see that the trend of sharp acceleration of prices in the US relative to the lagged official CPI data continues, and looks consistent with a 3% number, rather than the 2.1% we saw for February. No wonder TIPS are massively outperforming nominal US Treasury bonds. The 5 year US breakeven inflation rate has risen from 0.75% in early 2010 to 2.25% today.

Finally, given the splendid weather in the UK this weekend, please enjoy this spiffing photograph of me out on my velocipede on the Tweed Run through London. Similar photos are likely to also be found soon on the Sartorialist website.

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An update on the impact of the VAT rises in the UK compared to Australia and Japan

Here’s an update of a slide we produced a year ago following the January 2010 move back to 17.5% VAT from the 15% emergency rate.  We were comparing the UK’s retail sales numbers to those in Australia and Japan around the time of their consumption tax hikes, and asking whether we’d see pre-loading of purchases ahead of the sales tax and a collapse back afterwards.  The blue line shows that there was some deterioration in sales post the tax rise,  but it was probably not as pronounced as we might have expected.


With a move up in VAT again, this time to 20%, we can see how things are going this year.  Remember that December’s weather was pretty grim, and that the VAT hike was on 4th January – so there was pent up demand post Christmas and 3 days of shopping in January before the hike came in.  We can see that sales rose in January – which wasn’t in the script!   Last week though we saw the release of February’s official retail sales data showing a fall of 0.8% compared with January.  Department store sales were especially weak (down 3.2% on the month).  If we see a similar pattern to last year, we could expect the year on year rate of retail sales growth to turn negative hereafter. 

The VAT hike might actually turn out to be relatively trivial to consumers in the scheme of things.  Whilst sales fell, shops saw the biggest increases in prices (the deflator) for years – this was the biggest month on month increase in the price deflator since the series began in 1988, and only a part of this was due to the VAT rise.  Clothing and footwear inflation was especially strong.  The next few months could be very tough for retailers.

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Igor, he’s alive! – the corporate linker market shows signs of life

Has Bristol Water opened the tap on corporate inflation linked bond issuance? The water utility company came to market last Friday with a small £40m 30 year deal which pays a coupon of 2.701% plus inflation.

The interest payments on corporate inflation linked bonds – as the name suggests – move in line with inflation. Each issue has its own quirks but, as an example, the Bristol Water new issue pays a coupon of half of 2.701% every six months, uplifted by the change in the UK Retail Prices Index from issue (there’s a 3 months lag in the inflation number used because of the delay in collecting and releasing the inflation statistics).  The final redemption proceeds in March 2041 are also uplifted to reflect inflation over the lifetime of the bond (giving a “real” return).  The bond mechanics are pretty similar to those in the index-linked gilt market, although in this case there is a credit spread as well as the underlying real yield.  In this case the bond priced at 200 bps over the 2040 index linked gilt, reflecting both credit risk (Bristol Water is an investment grade company, Baa1 rated by Moody’s) and something for illiquidity (£40 mn is one of the smallest corporate bond deals).

We haven’t had any corporate linker issuance for a year or so but it appears that some firms are now looking at it as an option – we’ve been approached by 3 other issuers in recent months who are considering issuance. Maybe it’s the sustained elevated level of inflation – RPI is currently at 5.5% year on year – that is giving these companies pause for thought. If, like Bristol Water and other utility companies, your revenues are explicitly linked to RPI (due in this case to Ofwat, the UK water regulator) it is eminently sensible to have your liabilities linked to it also. When inflation starts to recede you don’t want to be left with fixed debt payments while your revenues are falling away.

Is there likely to be issuance outside of the utility sector though?  Why would corporates issue inflation linked debt in a world where inflation is high and rising?  At least when governments issue inflation linked bonds they have some control over keeping inflation low (through tighter fiscal and monetary policy).  Well, outside of the utility sector another big type of issuer is infrastructure related companies.  Operators of toll bridges (Severn Bridge in the UK, Oresundsbro Konsortiert which runs the bridge between Sweden and Denmark), railways (RFF in France), and PFI projects (Kings College Hospital) all have inflation linked revenues.  We also have Tesco – a supermarket which sells most of the things in the inflation basket nowadays – some banks, and a handful of other issuers.  But are corporate treasurers going to want to have borrowings linked to consumer prices at a time when inflation expectations are on the rise?  On the whole probably not, although the inflation swaps market (a form of derivative where fixed rate payments are switched for payments linked to inflation) allows borrowers to issue debt to match investors’ demand.  In the end though you still need to find somebody who is happy to “pay” inflation.  So the inflation market is unlikely to ever grow to anything like the size of the traditional corporate bond market, but with investor demand for inflation protection growing, some issuers will see this as an attractive form of issuance much in the same way that the high yield market grew from nothing in Europe at the end of the1990s to the big and liquid asset class it is now on the back of investor demand.

We’re pretty keen on corporate linkers here, not just because we think 2011 is a year of persistently high RPI, but also because they look good value relative to ordinary corporate bonds.  For example I could buy a Tesco 2016 index linked bond at 1.2% more yield than the equivalent index linked government bond, or I could buy the Tesco 2016 conventional bond at 0.9% more yield than the equivalent conventional government bond.  This is the illiquidity premium. Long may it persist, but whilst it does it probably acts as another reason why we shouldn’t expect bumper issuance in the asset class.  Corporate treasurers and CFOs should however get in touch if they feel we could be of help!

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