Issuu

Inflation as an Asset Class Ralph Segreti Global Inflation Linked & Rates Total Return Product Manager

Intro to the Inflation-Linked Markets

Globally inflation-linked continues to grow   

All G7 countries now inflation-linked issuers. Largest G7 issuers in 2007 US, UK and Japan. Euro area overall now second largest market. Brazil largest (USD130bn value) and biggest issuing emerging market, only became internationalised in 2006. Strong performance here has encouraged increased international activity in other emerging markets. 1600

Barcap forecasts

1400

700

1200 1000

US Barclays Capital Inflation-Linked Index Market Value ($bn) Euro area Global (LHS)

600

400

Japan

200

600 500

800

0 Jan 00

800

400 300 200 100

Other developed

0 Jan 01

Jan 02

Jan 03

Jan 04

Jan 05

Jan 06

Jan 07

Jan 08

Thanks to better modeling & corporate paying, swaps now centerpiece of European/UK markets

Structured products increasingly utilized to enhance yield & implement complex strategy

Rates

Hybrids

Credit

Sovereign Issuance

Commodity Hybrids/CCO

Sovereign Issuance

Corporate Issuance

Inflation Derivatives

Equity Hybrids

Infl. Derivatives

I/L CDO

Inflation/CMS

Structured Notes

Repackaged Notes

Quantoâ€™d Notes

CRA

Structured Notes Structured & Bespoke Solutions TRS

Inflation Capped Floaters

Regional TRS

Other LDI/ALM Property Derivatives UK Property Certificates I/L CDs, Deposit Accounts & GICs White Label UCIT-III Mutual Funds

FX Hybrids Multi CCY/ Cross Market

Dynamic Indices

NBT/Infrastruct ure/PFI

Pooled Liability Funds/Portable Alpha

Correlation /Delineated Infl.

Emerging Markets Poised to be Driver of Future Bond Growth Â

Brazil

Mexico

Argentin a

Chile

Colomb ia

South Africa

Poland

Turkey

South Korea

Securiti es

NTN-Bs, NTN-Cs (12, 5)

Udibonos (8)

BCUs (10)

TES UVRs (8)

4 bonds

1 bond

Maturiti es

Up to 2045

Up to 2035

Bodens, Bocones, Restructur ed debt (7) Up to 2038

Up to 2022

Up to 2023

Up to 2033

2016

2012

2017

Size (local fx)

BRL 251bn

MXN 172bn

ARS 167bn

CLP 2,050bn

COP 21,300bn

ZAR 44.7bn

PLN 6.4bn

TRY 4.1bn

KRW 625bn

Size (USD)

122bn

16bn

54bn

4bn

10bn

6bn

2bn

3bn

1bn

Size (% of local debt) Inflation Index

23%

10%

58%

13%

22%

IPCA, IGP-M

UDI

CER

UVR

CPI

Primary issuanc e Seconda ry market

Mthly

Twice a month

Qtly

Very Liquid: BRL1.2b n/ day; bid-offer

Liquid:

Liquid: Bidoffer 5 bp

Liquid bmks: Bid-offer 10 bp

Low liquidity: R50mn/ week; bid-offer

Barely trades outside of auction

MXN 500mn/ day; Bid-

Very liquid: USD500m n/ day; bid-offer

Local inflation & non standard indices becoming commonplace Barclays Capital provides swaps on the domestic inflation – Market is liquid & developed Barclays Capital provides swaps on the domestic inflation – Market is developing but regularly quoted Barclays Capital provides swaps on domestic inflation – Market is illiquid & developing

Why/How Investors Use the Inflation-Linked Market

Why/How Investors Use Inflation Tactical Opportunities  Strategic Diversification Benefits  Information content  What about equities & commodities? 

Tactical Opportunities  Outright

longs or shorts  Curve trades  Asset swaps  Forward rate trading  Cross market trades: US versus UK  Cross product trades: breakevens versus gasoline

Fundamentals and Breakevens: What Matters Where?



Tactical

Short End

Long End / Forwards

 

Strategic

Carry -Seasonals -Energy (Gasoline Futures)

Trends in Headline CPI Volatility

Model Based Leading Data -JOC/CRB/METALS -US$ (EUR, Trade Weighted) -Level of Rates

Trends in Core CPI Monetary Policy

Strategic Trades Tend to be Proactive Tactical Trades Tend to be Reactive

Tactical Cross Market Trading ď Ž

Example: Long US versus Europe

Tactical Driver: Energy and CPI Inflation    

The weight of energy within CPI has increased with higher prices However, the main impact on CPI comes through energy volatility Volatility of Energy CPI has been 18x that of non-Energy CPI over the past 5yrs More than 50% of CPI volatility comes from energy, despite the weight of only 8.7%.

Energy Weight within CPI

Source: Haver Analytics, BLS

Inflation Volatility

Source: Barclays Capital

Focus on Gasoline  



Gasoline (Motor Fuel) is the most important component of Energy CPI, both because of its weight and volatility. The published December weight likely understates the average gasoline weight because of seasonal factors. We estimate that the relative importance of gasoline reached as high as 5.9% in October 2005. Gasoline has been 32x as volatile as non-Energy inflation and within energy, has been more than twice as volatile as electricity inflation

Source: Haver Analytics, BLS

Source: Barclays Capital

Inflation Correlations Tell a Clear Story ď Ž

ď Ž

As a further demonstration of the importance of gasoline in the volatility of overall inflation, we highlight that Motor Fuel CPI is 93% correlated with Energy CPI and 77% correlated with overall CPI. Interestingly, even ex-Energy CPI, which makes up 92.3% of the CPI basket, is less correlated with CPI than gasoline. This alone helps explain why inflation-linked investors are so focused on energy price movements, and gasoline in particular.

CPI

Energy

CPI ExEnergy

Utility Gas Service

Household Electricity

Home Fuel Oil

CPI

1.00

Energy

0.75

1.00

CPI Ex-Energy

0.61

-0.05

1.00

Utility Gas Service

0.15

0.30

-0.12

1.00

Household Electricity

0.11

0.39

-0.26

-0.09

1.00

Home Fuel Oil

0.41

0.13

0.29

-0.18

1.00

0.77

0.93

0.07

0.14

0.11

0.40

Source: Barclays Capital

Motor Fuel

1.00

Strategic Investment  Efficient

frontiers lay the foundation  International accounts have their own reasons  The corporate sector moves in  Portfolio theory takes hold

Strategic Case for IL Products: TIPS dominate Nominal Treasuries in historical mean/variance Asset Split of Optimal Portfolio with TIPS TIPS Included

0.68

No TIPS

Average Monthly Return (%)

0.66

0.64

0.62

0.6

0.58 1

1.5

2.5

3.5

Risk (Monthly Standard Deviation)

Source: Barclays Capital

TIPS returns marginally higher than nominal Treasuries since start of market in 1997 but monthly returns volatility only 75% of a comparable basket of nominals.  Thus TIPS dominate Treasuries in an efficient portfolio  Long term TIPS returns may be slightly lower than nominals but volatility benefit should remain  TIPS dominance can continue as long as the liquidity premium for nominals is greater than the inflation risk premium 

Inflation within a diversified portfolio Average annual nominal portfolio returns, 1950 to date

Maximum and minimum returns, 1950 to date. Inflation reduces portfolio volatility



Strategic Case: Inflation Linked Afford Some Protection Vs Currency

In theory owning inflation linked bonds as part of unhedged portfolio reduces returns volatility from currency fluctuations, particularly longer term as inflation and currency movements should correlate. In practice long term link between small moves in currency and inflation not strong. Inflation expectations move in response to currency movements , which makes medium term link between inflation linked returns more correlated with currency than CPI is. Since 2000, monthly correlation has been 85%. Short term correlations increased from late 2004 as more central banks started to buy TIPS. Correlation is stronger in 10yr sector than elsewhere on curve.



2.5% 2.0%

Consumer Goods Ex Auto Import Prices

-15%

Trade Weighted $

-10%

1.5%

100

US TIPS index performance versus nominal Treasuries Broad Trade Weighted $ (RHS inv)

105

100

110

-5%

1.0%

0.5% 0.0%

]

-0.5%

115 120

10%

-1.0%

15%

SOURCE (BOTH): Barclays Capital

Jul-06

Jan-07

Jul-05

Jan-06

Jul-04

Jan-05

Jul-03

Jan-04

Jul-02

Jan-03

Jul-01

Jan-02

Jul-00

Jan-01

Jul-99

Jan-00

Jul-98

Jan-99

Jul-97

Jan-98

Jul-96

Jan-97

Jul-95

Jan-96

Jan-95

-1.5% -2.0%

105

20%

125 85

80 Jan97

130 135 Jan98

Jan99

Jan00

Jan01

Jan02

Jan03

Jan04

Jan05

Jan06

Interest rate and inflation risk mitigation

Pension Plans Utilize Inflation Swaps to Defease Liabilities  Full hedge design:   

A series of interest rate swaps whose notionals are tied to the identified interest rate exposure over the maturity range being hedged The hedge is implemented concurrently with inflation swaps to lock-in real interest rates Hedging possible out to 50 years. Precise hedging term to be decided nearer implementation in consideration of the traded term structure of real rates to maximise average yield

 Partial hedge design:

3.0%

90 80

2.5% 70 2.0%

60 50

1.5% 40 1.0%

Tot al liabilit ies [ RHS]

0.5%

Swap real yield [ LHS] 0.0% 2006

20 10 0

2011

2016

2021

2026

2031

2036

2041

2046

2051

Projected Cashflow (£m)



Emphasise hedging of the short to medium term liabilities (say out to 25 years) where yields are higher. This also correlates better with FRS17 calculations Combine inflation hedge with nominal rate swaptions to “collar” rate risk exposure

Real intrest rate



Corporates utilize inflation to hedge various liabilities 

Corporate Inflation Risk Inflation-linked procurement contracts  Cost of Living Adjustment (COLA)  Minimum Wage Indexation  Property Rents 



Example below diagrams a current discussion with a corporate looking to offer inflation protection to supplier and purchase offsetting protection from Barclays

Example: Corporate Looking to Offer Inflation Protection to Supplier and Purchase Offsetting Protection from Barclays using CPI Caps

Manufacturer Manufacturer Purchases CPI caps to match Supplier Contracts Barclays Barclays

Procurement Contracts with Inflation escalation above Strike

Supplier Supplier

Example: Corporate Looking to Hedge Cost of Living Adjustment to Employees Using Inflation Swap

Manufacturer Manufacturer

Inflation Adjusted Wage

Fixed Rate

Inflation Adjusted Rate

Barclays Barclays

COLA Wage COLA Wage Earner Earner

Inflation Swaps also Essential for PFI/PPP Financing & Hedging There are three principal financing routes for achieving inflation hedging. The choice of route depends firstly on the feasibility of each one in the size and risk of the project, and then on the relative pricing of each of the feasible options.  The loan is hedged into fixed rates as usual with an Interest Rate Swap. Loan Financing + Loan Financing +  Separately, the real revenue stream compounded by inflation is swapped Revenue Revenue Swap Swap

Loan Loan Financing Financing + + Revenue Swap Revenue Swap

Fixed Fixed Bond Bond + + Liability Swap Liability Swap

Direct Direct IL IL Bond Bond Financing Financing

for the same real revenue stream but inflated by a fixed inflator. Thus, the project has effectively fixed the rate of inflation on its revenues.



This is the same as the above except that the loan and interest rate swap is replaced by a fixed rate bond



A fixed rate bond is issued by the borrower. The bond cashflows are then swapped to create a “synthetic” IL-bond profile.



This route has recently been cheaper than issuing direct inflation-linked bonds due to asymmetries of supply and demand in the inflation market.



An inflation-linked bond is issued by the borrower which pays a real coupon, and a real uplift on each principal repayment.



There is therefore no derivative required to hedge inflation.

Information Content ď Ž Forward

rates closely watched ď Ž But the market is watching the watchers

Forward breakevens useful measure of expectations & risk premia 5yr5yr forward TIPS breakevens remain favoured measure by Fed of structural inflationary fighting credibility.  Euro breakevens eased on back of ECB hawkishnes, now at one year lows.  UK forwards close to multi-year high. Not inconsistent with increases in headline RPI or public surveys of inflation expectation, but sector stands out as rich on curve. 

3.4% 3.2%

TIPS 5yr5yr forward breakeven UK zero-coupon inflation swap 5yr5yr forward brekeven €i zero-coupon inflation swap 5yr5yr forward breakeven

3.0% 2.8% 2.6% 2.4% 2.2% 2.0% Jul 04

Oct 04

Jan 05

Apr 05

Jul 05

Oct 05

Jan 06

Apr 06

Jul 06

Oct 06

Jan 07

Forward inflation swaps routinely traded 1yr forward breakevens

3.4

3.2

1yr forward swap real yield

2.8

3.0 2.8

2.4

2.6 2.0

2.4 2.2

1.6

2.0

EUR HICPx

1.8

French CPIx

1.6

UK RPI

1.4

EUR HICPx French CPIx

1.2

UK RPI

0.8



 

10y

15y

20y

25y

30y

10y

15y

20y

25y

Forward curves are useful to assess value but are increasingly traded directly in both breakeven and real yield. Generic inflation swaps are zero coupon so forward trading easier than in bonds. Convexity adjustments are small but rebalancing needed as positions acquire value. European inflation swaps markets see active trading in forward breakevens and real yields, including spreads between Euro HICPx, French CPIx and UK RPI. 5yr 5yr most commonly traded breakeven forwards, partly due to importance attached to interpretation by central banks, particularly Fed. Barclays Capital trades this in Japanese CPI (63 mid) as well as more established markets.

30y

US inflation expectations correlate with business cycle fluctuations 1.5 1.0

3.50

Global Business Confidence (LHS) US 5yr, 5yr forward breakeven inflation (RHS)

3.00

0.5

2.50

0.0

2.00

-0.5

1.50

-1.0

1.00

-1.5

0.50

-2.0

0.00

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Inflation Markets as an Information Tool: Fed Watching the Markets Watching the Fed US BE model: Business sentiment, gasoline prices and monetary 



Inflation markets are impacted by Fed Policy:  Breakeven model incorporates business sentiment, gasoline prices and monetary policy expectations  The model implies that a 10bp steepening of the fed funds curve is associated with a 3bp move higher in breakevens Fed watches inflation expectations with a focus on 5yr forward 5yr breakevens  Fed Gov Mishkin: “The most important development in monetary economics that I have witnessed over my now-long career has been the recognition that expectations are central to our understanding of the behavior of the aggregate economy.”  Chicago Fed Pres Moskow: “If measures of inflation expectations were to rise persistently, then policy would clearly have to be tightened further.“  St Louis Fed Pres PooleL “If the inflation rate rises in a sustained fashion and particularly if inflationary expectations start to develop, that is a harder process to reverse…I pay a lot of attention to inflation expectations.”

expectations

5yr5yr Breakevens

What about equities & commodities?  Analysis

of returns  Balanced portfolios necessary  Is real return the true asset class?

Another look at our efficient frontiers, this time with commodities Global linkerswith commodities

0.68 100%

0.64

Global Linker Index

90%

GSCI

80%

0.6

TIPS

Monthly return (%)

70%

0.56 0.52 0.48 0.44 0.5

0.7

1.1

1.3

Corporate Index

No linkers with commodities

50%

TIPS with commodities

40%

20% max on linkers and commodities

30%

No linkers, no commodities

20%

Treasury

10%

Mortgage

Source: Barclays Capital 0.9

S&P 500

60%

Global linkers with commodities

1.5 1.7 1.9 Monthly volatility (%)

2.1

2.3

2.5

World Government Bond Index High Yield Index

0% 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3

ď‚§ The highest efficient frontier includes both commodities and global linkers ď‚§ In fact, as allowed risk is increased, the optimal portfolio contains nothing but commodities and linkers

Constraints are necessary, but real assets are clearly favored 100%

No Linkers, CommoditiesUnconstrained Global Linker Index GSCI

90% 80%

TIPS

70%

100%

Max 20% Linkers, 20% Commodities Global Linker Index

90%

GSCI

80%

TIPS

70%

60%

S&P 500

60%

S&P 500

50%

Corporate Index

50%

Corporate Index

40%

World Government Bond Index High Yield Index

40%

World Government Bond Index High Yield Index

Treasury

20%

Mortgage

10%

30% 20% 10% 0%

Capital 0.7 0.8 Source: 0.9 1.0 1.1 Barclays 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3

30%

Treasury Mortgage

0% 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3

ď‚§ When linkers are excluded, the optimal portfolio overweights mortgages for low risk tolerances and picks up corporates, S&P and commodities as allowed risk rises. ď‚§ When linkers and commodities are constrained to 20% each, linkers hit this max at relatively low risk and commodities hit the max as risk is increased.

Real returns under different economic stages 20%

Strong inflation & growth Strong growth & low inflation Weak growth and inflation High inflation & weak growth

Average Annual Real Total Returns

15%

10%

-5%

-10% Equities

Bonds

Linkers *

Art

Property

Commodities

Real asset returns ~ deflation, stagflation and low stable inflation

Equities Gilts Inflation Property Commodities

2002 -24.5 6.7 2.9 6.6 16

1979 -4.9 -11 17.2 5.1 5

1974 -58 -29 19.1 -29.4 15.8

1929 -14.1 -1 -0.6

Returns during the 1970s were narrowly distributed

UK all property

2.66%

US residential real estate

2.64%

UK equity

0.40%

US equity

1.40%

UK bonds

-3.20%

US bonds

-3.60%

UK Cash

-3.10%

US cash

-1.10%

Commodities

13.16%

Oil

24.84%

Commodities Oil

7.27% 18.90%

Rising oil prices derate US equity valuations 18.0

US 12 mnth forward PE

17.5

Forward PE regressed from Oil Assuming $70 oil

17.0 16.5 16.0 15.5 15.0 14.5 14.0 Nov 04

Mar 05

Jul 05

Nov 05

Mar 06

Jul 06

Nov 06

Mar 07

Volatile assets will not provide an adequate short run inflation hedge Volatility of annual returns

Volatility over the last 30 years

Minimum holding period to ensure inflation protection

Holding period (years)

10 5

0 UK equity Commodities UK bond

Property UK Linkers UK Inflation UK cash

Equities

Property

Commodities

UK linkers*

Conclusions  Inflation-linked

markets have developed globally in a logical manner  Strategic allocations are taking hold for diversification reasons  Advances in modeling have allowed complex solutions to be adopted in different areas  Information content in the markets is closely watched, but still valid  As the market evolves Real Return likely to emerge as the true asset class

Debt DebtHouse HousePoll Poll Inflation InflationDerivatives Derivatives House of House ofthe theYear Year

No No11Inflation-Linked Inflation-Linked Products Products

Inflation InflationDerivatives Derivatives House of House ofthe theYear Year

January January2007 2007

June June2006 2006

January January2006 2006

Institutional InstitutionalInvestor Investor End User Survey End User Survey

No No 11 Euro Euro Inflation Inflation Swaps Swaps

No No 11 Sterling Sterling Inflation Inflation Swaps Swaps

No No 11 US US Dollar Dollar Inflation Swaps Inflation Swaps

June June2006 2006

Disclaimer This

presentation has been prepared by Barclays Capital, the investment banking division of Barclays Bank PLC ("Barclays"), for information purposes only. This document is an indicative summary of the terms and conditions of the securities/transactions described herein and may be amended, superseded or replaced by subsequent summaries. The final terms and conditions of the securities/transactions will be set out in full in the applicable offering document(s) or binding transaction document(s). This document shall not constitute an underwriting commitment, an offer of financing, an offer to sell, or the solicitation of an offer to buy any securities described herein, which shall be subject to Barclays’ internal approvals. No transaction or service related thereto is contemplated without Barclays' subsequent formal agreement. Barclays is acting solely as principal and not as advisor or fiduciary. Accordingly you must independently determine, with your own advisors, the appropriateness for you of the securities/transaction before investing or transacting. Barclays accepts no liability whatsoever for any consequential losses arising from the use of this document or reliance on the information contained herein. Barclays does not guarantee the accuracy or completeness of information which is contained in this document and which is stated to have been obtained from or is based upon trade and statistical services or other third party sources. Any data on past performance, modelling or back-testing contained herein is no indication as to future performance. No representation is made as to the reasonableness of the assumptions made within or the accuracy or completeness of any modelling or back-testing. All opinions and estimates are given as of the date hereof and are subject to change. The value of any investment may fluctuate as a result of market changes. The information in this document is not intended to predict actual results and no assurances are given with respect thereto. Barclays, its affiliates and the individuals associated therewith may (in various capacities) have positions or deal in transactions or securities (or related derivatives) identical or similar to those described herein. This document is being made available in the UK to persons who are investment professionals as defined in Article 19 of the FSMA 2000 (Financial Promotion Order) 2005. Outside of the UK, it is directed at persons who have professional experience in matters relating to investments. Any investments to which this document relates will be entered into only with such persons. This document is not for distribution to retail customers. NO ACTION HAS BEEN MADE OR WILL BE TAKEN THAT WOULD PERMIT A PUBLIC OFFERING OF THE SECURITIES DESCRIBED HEREIN IN ANY JURISDICTION IN WHICH ACTION FOR THAT PURPOSE IS REQUIRED. NO OFFERS, SALES, RESALES OR DELIVERY OF THE SECURITIES DESCRIBED HEREIN OR DISTRIBUTION OF ANY OFFERING MATERIAL RELATING TO SUCH SECURITIES MAY BE MADE IN OR FROM ANY JURISDICTION EXCEPT IN CIRCUMSTANCES WHICH WILL RESULT IN COMPLIANCE WITH ANY APPLICABLE LAWS AND REGULATIONS AND WHICH WILL NOT IMPOSE ANY OBLIGATION ON BARCLAYS OR ANY OF ITS AFFILIATES. THIS DOCUMENT DOES NOT DISCLOSE ALL THE RISKS AND OTHER SIGNIFICANT ISSUES RELATED TO AN INVESTMENT IN THE SECURITIES/TRANSACTIONS. PRIOR TO TRANSACTING, POTENTIAL INVESTORS SHOULD ENSURE THAT THEY FULLY UNDERSTAND THE TERMS OF THE SECURITIES/TRANSACTION AND ANY APPLICABLE RISKS. THIS DOCUMENT IS NOT A PROSPECTUS FOR ANY SECURITIES DESCRIBED HEREIN. INVESTORS SHOULD ONLY SUBSCRIBE FOR ANY TRANSFERABLE SECURITIES DESCRIBED HEREIN ON THE BASIS OF INFORMATION IN THE RELEVANT PROSPECTUS (WHICH HAS BEEN OR WILL BE PUBLISHED AND MAY BE OBTAINED FROM BARCLAYS), AND NOT ON THE BASIS OF ANY INFORMATION PROVIDED HEREIN. Barclays Bank PLC is registered in England No. 1026167. Registered Office: 1 Churchill Place, London E14 5HP. Copyright Barclays Bank PLC, 2007 (all rights reserved). This document is confidential, and no part of it may be reproduced, distributed or transmitted without the prior written permission of Barclays. Barclays Capital is the investment banking division of Barclays Bank PLC, which is authorised and regulated by the UK Financial Services Authority and a member of the London Stock Exchange.